CHAPTER ONE

OVERVIEW OF COST ACCOUNTING

1.1 Cost Accounting verses Management and Financial Accounting
There are three specialized fields of accounting. Those are financial accounting, management
accounting and cost accounting. Financial accounting focuses on reporting to external parties
such as investors, government agencies, banks, and suppliers. It measures and records business
transactions and provides financial statements that are based on generally accepted accounting
principles (GAAP).
Management accounting measures, analyzes, and reports financial and nonfinancial
information that helps managers make decisions to fulfill the goals of an organization. Managers
use management accounting information to develop, communicate, and implement strategy.
They also use management accounting information to coordinate product design, production, and
marketing decisions and to evaluate performance. Management accounting information and
reports do not have to follow set principles or rules. The key questions are always
(1) How will this information help managers do their jobs better, and
(2) Do the benefits of producing this information exceed the costs?
Cost accounting measures, analyzes, and reports financial and nonfinancial information relating
to the costs of acquiring or using resources in an organization. Cost accounting provides
information for both management accounting and financial accounting.

1.2 Cost Terms and Concepts

Cost defined: Accountant usually defines cost as a resource sacrificed or forgone to achieve a
specific objective. It is usually measured, in the conventional accounting way, as monetary unit
(for example birr) that must be paid for goods and services. An actual cost is the cost incurred
(a historical or past cost), as distinguished from a budgeted cost, which is a predicted or
forecasted cost (a future cost).
Cost Accounting Defined: The institute of cost and management accountings London has
defined the cost accounting as “The application of costing and cost accounting principles
methods and techniques to the science, art and practice of cost control and the ascertainment of
profitability as well as presentation of information for the purpose of managerial decision
making.

To guide decisions, managers want data for a verity of purposes. They want the cost of
ʺsomethingʺ. We call this something a cost object (or cost objective).
A cost object is defined as any activity or item for which a separate measurement of costs is
desired. It is a key feature of management accounting. A cost object can be:
o an activity or operation in which resources are consumed or received
o a product (good) or service
o a project

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 o a department
o a program
Summary of the cost objects

Cost-Object

Activity or Product or Project Departments Program

operation services

Cost Accumulation and Assignment

A cost system typically accounts for costs in two broad stages:
(1) it accumulates costs by some “natural” classification such as raw materials used, fuel
consumed, or advertising placed, and then
(2) it assigns (allocates or traces) these costs to cost object.
Cost accumulation is the collection of cost data in same organized way through an accounting
system.
Cost assignment is a general term that encompasses both cost tracing and cost allocation to cost
objects.
Cost tracing refers to the assignment of direct costs to a particular cost object.
Cost allocation is a term used to describe the assignment of indirect costs to a particular cost
object.
Cost Driver
A cost driver is a variable, such as the level of activity or volume that causally affects costs over
a given time span. An activity is an event, task, or unit of work with a specified purpose—for
example, designing products, setting up machines, or testing products.
The level of activity or volume is a cost driver if there is a cause-and-effect relationship between
a change in the level of activity or volume and a change in the level of total costs. For example,
if product-design costs change with the number of parts in a product, the number of parts is a
cost driver of product-design costs. Similarly, miles driven are often a cost driver of distribution
costs.
The cost driver of a variable cost is the level of activity or volume whose change causes
proportionate changes in the variable cost. For example, the number of tables produced is the
cost driver of the total cost of tables. If setup workers are paid an hourly wage, the number of
setup hours is the cost driver of total (variable) setup costs.
Costs that are fixed in the short run have no cost driver in the short run but may have a cost
driver in the long run. Consider the costs of testing, say, 0.1% of the color printers produced at a

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certain plant. These costs consist of equipment and staff costs of the testing department that are
difficult to change and, hence, are fixed in the short run with respect to changes in the volume of
production. In this case, volume of production is not a cost driver of testing costs in the short run.
In the long run, however, plant will increase or decrease the testing department’s equipment and
staff to the levels needed to support future production volumes. In the long run, volume of
production is a cost driver of testing costs.
Relevant Range

A relevant range is the band of the cost driver in which a specific relationship between cost
(revenue) and cost (revenue) driver is valid. A fixed cost is fixed only in relation to a given
relevant volume of range (usually large) and a given time (usually a particular budget period).
For example the following diagram shows that a fixed cost level of $600,00 applies to a relevant
range of 30,000 to 95,000 machine hours – the cost drive per year. The diagram also shows that
operations on either side of the relevant range would result in different fixed costs. With output
the range from zero hours to 30,000 machines – hours, service and executive personal would
likely to be laid off. An increase in volume above 95,000-machine hours would increase fixed
costs. The business might hire additional personnel to help the increased operation. Fixed costs
may differ from one year to the next wholly because of changes in items other than the volume
of cost driver, such as rent terms, salary level, and property tax rates.

1.3 Classification of Costs

Direct material, Direct labor and manufacturing costs

Commonly Used Classifications of Manufacturing Costs

Three terms commonly used when describing manufacturing costs are direct material costs,
direct manufacturing labor costs, and indirect manufacturing costs. These terms build on the
direct versus indirect cost distinction we had described earlier, in the context of manufacturing
costs.
1. Direct material costs are the acquisition costs of all materials that eventually become part of
the cost object (work in process and then finished goods) and can be traced to the cost object in
an economically feasible way. Acquisition costs of direct materials include freight-in (inward
delivery) charges, sales taxes, and custom duties. Examples of direct material costs are the steel
and tires used to make Automobiles, and the computer chips used to make cellular phones.
2. Direct manufacturing labor costs include the compensation of all manufacturing labor that
can be traced to the cost object (work in process and then finished goods) in an economically
feasible way. Examples include wages/salaries paid to machine operators and assembly-line
workers who convert direct materials purchased to finished goods.
3. Indirect manufacturing costs are all manufacturing costs that are related to the cost object
(work in process and then finished goods) but cannot be traced to that cost object in an
economically feasible way. Examples include supplies, indirect materials such as lubricants,

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indirect manufacturing labor such as plant maintenance and cleaning labor, plant rent, plant
insurance, property taxes on the plant, plant depreciation, and the compensation of plant
managers. This cost category is also referred to as manufacturing overhead costs or factory
overhead costs.
Factors Affecting Direct/Indirect Cost Classifications
o The materiality of the cost in question
o Available information-gathering technology
o Design of operations
Variable Costs, Fixed Costs and mixed Costs
Based on their behavior patterns, costs can be classified as Variable Costs Fixed Costs and mixed
costs.
A variable cost changes in total in proportion to changes in the related level of total activity or
volume.
A fixed cost remains unchanged in total for a given time period, despite wide changes in the
related level of total activity or volume. Costs are defined as variable or fixed with respect to a
specific activity and for a given time period.
Unlike variable costs, fixed costs of resources (such as for line supervision) cannot be
quickly and easily changed to match the resources needed or used. Over time, however,
managers can take actions to reduce fixed costs.
A mixed Cost also called a semivariable cost/semi fixed cost - is a cost that has both fixed and
variable elements.
Inventoriable Costs and Period Costs
Inventoriable Costs: also called product costs, are all costs of a product that are considered
as assets in the balance sheet when they are incurred and that become cost of goods sold only
when the product is sold. For manufacturing-sector companies, all manufacturing costs are
inventoriable costs. Costs of direct materials, direct manufacturing labor costs, and
manufacturing overhead costs create new assets, starting as work in process and becoming
finished goods (the cellular phones). Hence, manufacturing costs are included in work-in-process
inventory and in finished goods inventory (they are “inventoried”) to accumulate the costs of
creating these assets.
When the cellular phones are sold, the cost of manufacturing them is matched against revenues,
which are inflows of assets received for products or services provided to customers. The cost of
goods sold includes all manufacturing costs (direct materials, direct manufacturing labor, and
manufacturing overhead costs) incurred to produce them. The cellular phones may be sold during
a different accounting period than the period in which they were manufactured. Thus,
inventorying manufacturing costs in the balance sheet during the accounting period when goods
are manufactured and expensing the manufacturing costs in a later income statement when the
goods are sold matches revenues and expenses.
Period Costs: are all costs in the income statement other than cost of goods sold. Period costs,
such as marketing, distribution and customer service costs are treated as expenses of the
accounting period in which they are incurred because they are expected to benefit revenues in
that period and are not expected to benefit revenues in future periods. Some costs such as R&D

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 costs are treated as period costs because, although these costs may benefit revenues in a future
period if the R&D efforts are successful, it is highly uncertain if and when these benefits will
occur. Expensing period costs as they are incurred best matches expenses to revenues.
1.4 The Flow of Costs in Manufacturing Firms
Cost accounting neither adds new steps to the familiar accounting cycle nor discards the
principles and procedures studied in financial accounting. Cost accounting consists of a system,
which is concerned with precise recording and measurement of cost elements as they originate
and flow through the productive processes. The flow is illustrated in the following diagram:
Materials inventory
Cash
Cost of Held in
Depreciable Assets, Accounts payable, Accruals etc
materials
Pay purchased
For

Requisitioned to
Pay for or allocate production

Direct labor Work in process

Direct materials
Factory overhead Direct Labor
Indirect labor Factory overhead
Indirect materials
Other overhead costs eg.
Factory heat, light ,power, Cost of Goods
insurance, deprecation etc. completed

Move to

Finished Goods inventory

Move to Cost of Goods
Sold

The manufacturing process and the physical arrangement of the factory are the basis for
determining cost accumulation procedures.
Generally the accounts which describe manufacturing operations are materials, payroll, factory
overhead control, and work in process, finished goods and cost of goods sold. These accounts

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are used to recognize and measure the flow of costs in each fiscal period from the acquisition of
materials through factory operations to the cost of goods sold.
The flow of costs to ledger accounts is based on source or transaction documents which must be
checked verified and vouched before they are journalized and posted. These documents are the
fundamental evidence at an accounting event. Some of the typical source documents which
support transitions involving the elements of manufacturing cost are identified in the following
table.
Cost Source Document
Material purchase invoices, materials requisitions, materials
returned slips, etc.
Labor Time tickets or time sheets, clock cards, job tickets,
etc.
Factory overhead Voucher prepared to set up depreciation or
prepaid expense, vendors’ invoices, utility bills,
time sheets, etc.
The flow of accounting information from source document to ledger accounts may be using the
journal voucher control system whether manual, mechanical or computerized, this system
involves the use of journal vouchers on which information from the source documents is
summarized and identified according to the chart of accounts. The journal voucher is the basis
for the preparation of journal entries which record the transactions for a given period and the
posting of these transitions to the ledger accounts. The journal voucher should indicate the
voucher number, the date, the accounts with their numbers or codes, the amounts to be debited or
credited, and approval. Columns may be added to accommodate the subsidiary ledgers details, or
these details may be posted directly from the source documents. In general, the matching of costs
and work flow is summarized below.

Procurement Production Working process Selling

1.5 Reporting Results of Operation

The results of operations of manufacturing fitm's are reported on the income statement. The
income statement of manufacturing firms has a section entitled the cost of goods sold. The cost
of goods sold by itself is determined by preparing a schedule termed as the schedule of the cost
of goods sold. Normally, it is not advisable to include this schedule on the income statement – as
it is much detailed. An option is to prepare the cost of goods sold schedule separately, and take
the last figure i.e. the amount for the cost of goods sold to the income statement. The cost of
goods sold schedule is therefore, prepared as follows.
Step 1: Cost of direct materials used: The cost of direct materials used is calculated
Beginning inventory of direct materials, ..….……………………. xxxx
Add: Purchases of direct materials during the period …………… xxxx
Deduct: Ending inventory of direct materials, ……………………….. xxxx
Direct materials used in the period ……………………………… xxxx

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Step 2: Total manufacturing costs incurred during a period. Total manufacturing costs refers
to all direct manufacturing costs and manufacturing overhead costs incurred during a given
period.
The cost of goods manufactured in 2011 is calculated as follows:
Direct materials used in the period ………………………………. xxxxx
Add: Direct manufacturing labor in the period ………………….. xxxxx
Manufacturing overhead costs in the period ……………… xxxxx
Total manufacturing costs incurred During a period …………. Xxxxx

Step 3: Cost of goods manufactured: refers to the cost of goods brought to completion,
whether they were started before or during the current accounting period. It is calculated as
follows:

Beginning work-in-process inventory, …………………………………. xxxx

Add: Total manufacturing costs incurred in the period …………………xxxx
Total manufacturing costs to account for ………………………… xxxx
Deduct: Ending work-in-process inventory, ………………………. xxxx
Cost of goods manufactured in 2011 …………………………… xxxx

Step 4: Cost of goods sold: The cost of goods sold is the cost of finished goods inventory sold
to customers during the current accounting period. This cost of goods sold is an expense that is
matched against revenues. The cost of goods sold for is computed as follows:

Beginning inventory of finished goods, beg…………… ………. xxxx

Add: Cost of goods manufactured in the period ………………… xxxx
Deduct: Ending inventory of finished goods, ending …………… xxxx
Cost of goods sold during a period ………………….. xxxx
Note: - these costs are all inventoriable costs.
- Goods completed during the period are transferred to finished goods inventory. These
costs become cost of goods sold in the accounting period when the goods are sold.
- The direct materials, direct manufacturing labor, and manufacturing overhead costs of the
units in work-in-process inventory and finished goods inventory (ending) will appear as an asset
in the balance sheet. These costs will become expenses in the next period when these units are
sold.

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