CHAPTER ONE

1. Overview of Cost and Management Accounting

1.1 Objectives of Cost & Management Accounting
 To ascertain the cost per unit of the different products manufactured by a business concern.
 To provide a correct analysis of cost both by process or operations and by different elements of cost.
 To disclose source of wastage whether the material, time or expense or in the use of machinery,
equipment and tools and to prepare such reports which may be necessarily to control such wastage.
 To provide requisite data and serve as a guide to price fixing of products manufactured or service
rendered.
 To ascertain the profitability of each of the product and advise the management as to how these
profits can be maximized.
 To advise the management on future expansion policies and proposed capital projects.
 To present and interpret data for management planning, evaluation of performance and control.
 To help in the preparation of budget and implementation of budgetary control.
 To guide management in the formulation and implementation of incentive bonus plans based on
productivity and cost savings.
 To supply useful data to management for taking various financial decisions such as introduction of
new products, replacement of labor by machines.
1.2 Cost and management accounting in comparison with financial accounting
Financial accounting includes all the principles that regulate the accounting for and reporting for financial
information that must be disclosed to people outside the company, to stockholders, bankers, creditors, and
brokers. In contrast, management accounting exists primarily for the benefit of those inside the company, the
people who are responsible for its operations.
Many of the procedures and principles that stem from financial accounting also apply to management
accounting. Depreciation techniques, cash collection and disbursement procedures, inventory valuation
methods, and the recognition of what is an asset or a liability are all essential to the study of management
accounting. But, because their output is communicated to different audiences for different reasons, financial
accountants and management accountants follow different rules. The rules of management accounting are
somewhat less defined and place fewer restrictions on the accountant’s day-to-day activities.
COMPARISON OF FINANCIAL AND MANAGEMENT ACCOUNTING

Areas of Comparison Financial Accounting Management Accounting

1. Primary users of Persons and organization Various levels of internal management

information outside the business entity
3. Restrictive guidelines Adherence to GAAP No formal guidelines or restrictions,
only criterion is useful
4. Units of measurement Historical (past) dollars Any useful monetary (historical and
future) or physical measure such as
machine hours, labor hours etc
5. Focal and emphasis point past oriented Future oriented
for analysis

1
 6. Frequency of reporting Periodical on a regular basis When ever needed; may not be on a
regular basis
7. Types of report It provides only financial It provides both financial and non
information financial information .

Cost Accounting
Cost accounting is the process of accumulating the cost of manufacturing and other functional process and
identifying these costs with unit produced or some other object.
It measures and reports financial and other information’s related to the organization’s acquisition or
consumption of resource.
Cost accounting is applied in any type of organization but primarily applied in manufacturing organization
that combine and process raw martial in to finished product.
Cost accounting provides information for both management accounting and financial accounting.
-It is a subfield of managerial accounting that interfaces with both managerial and financial accounting.
1.3 Cost classification concepts and terms
1.3.1 Cost terminologies
Many accounting reports contain several cost terminologies. A good understanding of the different cost
terminology is essential at least for the following two reasons.
 It enables accounting information users to best use the information provided.
 Uses of common terminology avoid confusion and misunderstanding.
The following are some of the terms used in cost accounting
COSTS: Accountants usually define cost as resource scarified or forgone to achieve a specific objective. It
refers to an out lay or expenditure of money to acquire goods and services in the course of generating
revenue. For instance purchase of raw martial represent a cost as the raw material is used to produce finished
goods that generate revenue when sold.
However some disbursements are not costs .For example, the payment of dividend is disbursement but it
does not help to generate revenue, hence it is not a cost. All costs initially represent an asset.
EXPENSES: As the asset is used in generating revenue, the amount consumed becomes an expense.
Therefore expense is an expired cost. The cost of asset used should then be recognized as expense to properly
match revenue and expense in the process of determining the income of the organization over a given period.
For instance, insurance premium paid in advance to serve the coming period are initially recognized as asset,
but as time passes on, the asset is continually converted in to an expenses. Another example may be a motor
vehicle bought for uses for the coming five years is an asset when initially purchased. However, as the asset
is used up in the process of generating revenue, the cost gradually becomes an expense. Thus, expense is
expired costs or costs used up in the course of generating revenue.
LOSSES: Sometimes a firm may incur a cost that produces neither immediate nor future benefit. This is
called a loss. For example damage caused by fir or flood on property held is a loss. It is associated with an
incidental transaction. Example:- loss sales of asset used in the business, loss from low suit settlement
…..etc.

2
COST OBJECT AND COST DRIVER
Cost object: is anything for which cost data are desired- including products, product lines, customers, jobs, and
organizational subunits or which is anything for which a separate measurement of costs is desired.
Cost driver: is any factor that affects the total costs. That is a change in the level of the cost driver will cause a
change in the total cost f related object. Any change made in any of the cost driver will cause a change in total
cost.
Examples:- number of units produced ,number of items distributed, number of customers, Mile driven for
transport cost, Length of time of call for telephone cost, Meter cub of water consumed for water cost, Unit
sold for cost of goods sold.
1.3.2 COST CLASSIFICATION
Cost classification: it is a process of grouping costs according to their common characteristics or a
systematic placement of like terms together according to their common features.
Cost may be classified in different ways based on different bases.
1. Time period point of view
From time period point of view cost are classified in to historical cost and budgeted cost. Historical cost are
costs incurred in the past period where as Budgeted costs are costs expected to be incurred in the future
period. For example, the 10,000 birr cost of a computer acquired in 2006 is a historical cost in the financial
statement of 2007. However the 12,000 birr cost to acquire a new computer in 2007 to replace the existing
one is a future cost
2. Classification cost on the financial statements
The value presented on the balance sheet for an asset is an unexpired cost, but the portion of an asset’s value
consumed or sacrificed during a period is presented as an expense or expired cost on the income statement.
3. Based on Cost assignment: is a general term that encom-passes both (1) tracing direct costs to a cost object
and (2) allocating indirect costs to a cost object.
A key question in cost assignment is whether costs have direct or an indirect relationship to a particular cost
object.
Direct costs are costs that are directly traceable to the product.
Example: -direct material cost, Direct labor cost .
Indirect cost (manufacturing over head or factory over head): are cost which are not directly traceaced to
the product but allocated to it using some criteria. Example:
 Cost of electricity  Cost of different utilities
 Depreciation of equipment  Cost of repair and maintenance
 Indirect labor  Insurance for the plant…….etc.
 Indirect material
Cost allocation: is used to describe the assignment of indirect costs to a particular cost object.
4. Cost behavior point of view
Cost behavior: refers to how a cost reacts to changes in the level of activity. As the activity level rises and
falls, a particular cost may rise and fall as well or it may remain constant. For planning purposes, a manager
must be able to anticipate which of these will happen; and if a cost can be expected to change, the manager
must be able to estimate how much it will change. To help make such distinctions, costs are often categorized
as variable or fixed.

3
 VARIABLE COST
 A variable cost is a cost that varies, in total, in direct proportion to change in the level of activity. The
activity can be expressed in many ways such as units produced, units sold, miles driven, beds occupied, hours
worked and so on.
 A good example of a variable cost is direct materials. The cost of direct materials used during a period
will vary, in total, in direct proportion to the number of units that are produced.
 In variable cost, the total cost rises and falls as the activity level rises and falls. One interesting aspect of
variable cost behaviour is that a variable cost is constant if expressed on a per unit basis.
Example;-Let’s assume ABC company manufacture autos; each auto requires a battery that costs Br. 24 each. If
only 1 auto is manufactured the total variable cost for batteries is Br. 24.
No. of Autos Produced Cost for Battery Total VC-Batteries
1 Br. 24 Br. 24
500 24 12,000
1000 24 24,000
Note: variable cost per unit remains constant when the level of production increased or decreased.
 FIXED COST
It is a cost that remains constant in total regardless of changes in the level of activity. Unlike variable costs,
fixed costs are not affected by changes in activity.
 Consequently, as the activity level rises and falls, the fixed costs remain constant in total amount unless
influenced by some outside force, such as price changes.
E.g.:- Rent Expense
 When we say a cost is fixed, we mean it is fixed within some relevant range. The relevant range is the
range of activity within which the assumptions about variable and fixed costs are valid.
 Fixed costs can create difficulties if it becomes necessary to express the costs on per unit basis. This is
because if fixed costs are expressed on a per unit basis, they will react inversely with changes in activity.
Example: Bati hospital rent machine for birr 8000 per month that tests blood samples for presence of leukaemia
cells.
Monthly Rental Cost No. of Tests Performed Average Cost per Test
Br. 8,000 10 Br. 800
8,000 500 16
8,000 2000 4

Behaviour of the Cost (within the relevant range)

Cost In Total Per Unit
Variable Cost Total variable cost increases and Variable cost remains constant per unit.
decreases in proportion to
changes in the activity level.

Fixed Cost Total fixed cost is not affected by Fixed costs decrease per unit as the
changes in the activity level activity level rises and increase per unit
within the relevant range. as the activity level falls.

4
Exercise: XYZ Company manufactures and sells products. The production can vary from 20,000 to 60,000
units. A partially schedule of the company’s total and per unit costs for the coming year follows:
Units produced and sold
20,000 40,000 60,000
Total costs:
Variable costs $ 80,000 ? ?
Fixed costs 100,000 ? ?
Total costs $ 180,000 ? ?
Cost per unit:
Variable cost ? ? ?
Fixed cost ? ? ?
Total cost per unit ? ? ?
Required:
1. Compute the schedule for XYZ Company’s total and per unit costs.
2. Determine the cost formula in the format of Y= bx+a
General cost Classification
1. Manufacturing Costs
Most manufacturing companies separate manufacturing costs into three broad categories: direct materials,
direct labor, and manufacturing overhead. A discussion of each of these categories as follows.
A. Direct Material cost: The materials that go into the final product are called raw materials. This term is
somewhat misleading, since it seems to imply unprocessed natural resources like wood pulp or iron ore.
Actually, raw materials refer to any materials that are used in the final product; and the finished product of
one company can become the raw materials of another company.
Raw materials may include both direct and indirect materials. Direct materials are those materials that
become an integral part of the finished product and whose costs can be conveniently traced to the finished
product. This would include, for example, the woods in production of wooden chair.
To be classified as a direct materials cost, the cost must be both of the following:
1. An integral part of the finished product
2. A significant portion of the total cost of the product
B. Direct Labor cost: Direct labor consists of labor costs that can be easily (i.e., physically and
conveniently) traced to individual units of product. Direct labor is sometimes called touch labor, since direct
labor workers typically touch the product while it is being made. Examples of direct labor include assembly-
line workers at car manufacturing Company, carpenters at the home builder.
Labor costs that cannot be physically traced to the creation of products, or that can be traced only at great
cost and inconvenience, are termed indirect labor. Just like indirect materials, indirect labor is treated as part
of manufacturing overhead. Indirect labor includes the labor costs of janitors, supervisors, materials handlers,
and night security guards. Although the efforts of these workers are essential to production, it would be either
impractical or impossible to accurately trace their costs to specific units of product. Hence, such labor costs
are treated as indirect labor.
C. Manufacturing Overhead cost: Manufacturing overhead, the third element of manufacturing cost,
includes all costs of manufacturing except direct materials and direct labor. Manufacturing overhead includes
items such as indirect materials; indirect labor; maintenance and repairs on production equipment; and heat

5
and light, property taxes, depreciation, and insurance on manufacturing facilities. A company also incurs
costs for heat and light, property taxes, insurance, depreciation, and so forth, associated with its selling and
administrative functions, but these costs are not included as part of manufacturing overhead. Only those
costs associated with operating the factory are included in manufacturing overhead. Various names are used
for manufacturing overhead, such as indirect manufacturing cost, factory overhead, and factory burden. All
of these terms are synonyms for manufacturing overhead.
Prime Cost and Conversion Cost
Two more cost categories are often used in discussions of manufacturing costs—prime cost and conversion
cost. These terms are quite easy to define. Prime cost is the sum of direct materials cost and direct labor cost.
Conversion cost is the sum of direct labor cost and manufacturing overhead cost. The term conversion cost
is used to describe direct labor and manufacturing overhead because these costs are incurred to convert
materials into the finished product.
2. Nonmanufacturing Costs
Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2) administrative costs.
Selling costs include all costs that are incurred to secure customer orders and get the finished product to the
customer. These costs are sometimes called order-getting and order-filling costs. Examples of selling costs
include advertising, shipping; sales travel, sales commissions, sales salaries, and costs of finished goods
warehouses.
A. Administrative costs include all executive, organizational, and clerical costs associated with the general
management of an organization rather than with manufacturing or selling. Examples of administrative costs
include executive compensation, general accounting, secretarial, office salary, office supplies, deprecation of
office building and equipment and similar costs involved in the overall, general administration of the
organization as a whole. Nonmanufacturing costs are also often called selling, general, and administrative
(SG&A) costs.
Product and Period Costs
 Product Costs
 Product costs include all cots that are involved in acquiring or making product- direct materials, direct labour,
and manufacturing overhead.
 Initially product costs are assigned to an inventory account on the balance sheet. When goods are sold, the
costs are released from inventory as expenses (cost of goods sold) and matched against revenue. For this reason
they are also known as Inventorable costs.
 Product costs are not necessarily treated as expenses in the period in which they are incurred. Rather they are
treated as expenses in the period in which the related products are sold. This means that a product cost such as
direct materials or direct labour might be incurred during one period but not treated as an expense until a
following period when the completed product is sold.
 Period Costs
 Period costs are all the costs that are not included in product costs. These costs are expensed on the income
statement in the period, in which they are incurred, the rules of accrual accounting.
 Period costs are not included as part of the cost of either purchased or manufactured goods like sales
commissions and office rent and all selling and administrative expenses are considered to be period costs.
Controllable and Uncontrollable Cost
Understanding the cost classifications of controllable and uncontrollable costs is vital in order to make a number

6
of business decisions. It assists businesses to reduce costs and make choices as to whether or not to proceed with
a certain decision. The key difference between controllable and uncontrollable cost is that controllable cost is an
expense that can be increased or decreased based on a particular business decision whereas uncontrollable cost is
a cost that cannot be increased or decreased based on a business decision.
 Controllable Cost
 Controllable cost is an expense that can be increased or decreased based on a particular business decision. In
other words, the management has the power to influence such decisions. These costs can be altered in the short
term. In general, costs relating to a particular business decision is controllable; if the company decides to refrain
from making the decision, the costs will not have to be incurred. The ability to control costs mainly depends on
the nature of the cost and decision-making authority of the managers.
Example; variable costs such as Direct material cost, direct labor, and variable overheads. Thus, if the increase
in output is avoided, the related costs can be controlled.
Incremental Cost
Incremental cost is the additional cost that will have to be incurred as a result of the new decision made.
Stepped Fixed Cost
Stepped fixed cost is a form of fixed costs that does not change within specific high and low activity level, but
will change when the activity level is increased beyond a certain point
Decision-making Authority
The majority of the costs are controllable by senior and middle management due to their decision-making
authority. Decisions relating to costs are taken by managers and operational staff is required to work towards
achieving the cost targets.
 Uncontrollable Cost
Uncontrollable cost is a cost that cannot be increased or decreased based on a business decision. In other words,
it is an expense that a manager has no power to influence. Many uncontrollable costs can only be altered in the
long term. If a cost has to be incurred irrespective of making a specific business decision, such costs are often
classified as uncontrollable costs. Similar to controllable cost, uncontrollable costs can also arise due to the
nature of the cost and decision-making authority of the managers.
Examples; fixed costs include rent, lease rental, interest expense and depreciation expense.
Regulated Costs with a Legal Binding such as tax expense, other government levies, interest expense, and
costs incurred to meet safety and other regulatory standards are often uncontrollable since related decisions are
taken by external parties.
Avoidable and unavoidable costs
Understanding the cost classifications of avoidable and unavoidable costs is vital in order to make a number of
business decisions. The key difference between avoidable and unavoidable cost is that avoidable cost is a cost
that can be excluded due to stoppage of conducting a business activity whereas unavoidable cost is a cost that
continues even if the activity is not performed.
 Avoidable cost is a cost that can be excluded due to stoppage of conducting a business activity. These costs
are only incurred if the company decides to proceed with a certain business decision. Further, avoidable costs are
direct in nature, i.e. they can be directly traced to the end product. Understanding such costs is advantageous to
businesses since it assists in identifying the costs that do not contribute to profits; thus, they can be eliminated by
discontinuing the non-profit making operations.

7
E.g. ABC Company is a large-scale manufacturing company that produces 5 types of consumer products. Each
product is completed in a separate production line and marketed and distributed separately. From the results for
the past two years, ABC had been experiencing reducing sales from one product due to competitor actions.
Thus, the management decided to discontinue the respective product; as such the production, marketing and
distribution expenses will be avoided.
Example: Variable cost are the main type of avoidable cost.
 Unavoidable costs are costs a company incurs irrespective of the operational decisions it makes.
Unavoidable costs are fixed and indirect in nature, meaning they cannot be easily traceable to the end product.
Examples of fixed costs include rent, lease rental, interest expense and depreciation expense.
E.g. DFE Company produces two different types of products, product A and product B, in the same factory.
Factory rent expense is $15,550 per month. Due to a sudden decrease in demand, DFE decided to stop the
production for product B. Irrespective of this decision, DFE still has to pay the rent of $15,550.
 Sunk Cost
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in
the future. Since sunk costs cannot be changed by any decision, they are not differential costs. Therefore, they
can and should be ignored when making a decision.
Example : assume that a company paid $60,000 several years ago for a special-purpose machine. The machine
was used to make a product that is now obsolete and is no longer being sold, the $60,000 originally paid for the
machine is a sunk cost that should be ignored in current decisions.

Budgeted, Standards and actual cost

 Budgeted cost
Budgeted cost is an estimate of the expenses that a company expects to spend going ahead. Or, we can say it is
the expenses that management estimates to pay based on forecasted revenue and sales. To meet the budgeted
cost, a company usually sets aside funds in advance or makes arrangements for a suitable credit facility.
A point to note is that the budgeted cost could be for the full business, a particular project, or a product. For
example, the estimated cost for a project would include all the expenses needed to complete the project. These
expenses could be raw materials, salaries of the participants’ and more. It also consists of both fixed and variable
costs, though they are budgeted differently.
For instance, if a company expects to increase production by 10%, then it would estimate the variable costs to
rise by 10% as well. However, there may or may not be a need to raise the fixed cost to adjust for the increase in
production.
 Standard costs
Standard costs are generally applicable in the case of manufacturing activities. These are the established or the
general costs, meaning the company knows beforehand how much it would have to spend per unit. We can also
say that it is the advance estimate of the actual costs. For instance, in a manufacturing organization, the standard
cost for the next year for direct materials, including the standard rate per unit and the standard quantity of raw
material per unit.
Example:
ABC Inc. manufactures air-conditioners. As per established industry norms and the company’s historical costs,
the standards have been set per unit as follows:

8
 Standard material cost: $75

 Standard direct labor: 8 man hours @ $10 per hour

 Standard overheads: $50
In the month of March 2021, ABC Inc. incurs the following actual costs in producing 100 AC units:
Actual costs Standard Variance
(A) costs (A-B)
(B)
Material cost 7300 7500 -200
Labor cost 8500 8000 500
Overheads cost 5700 5000 700

The labor cost and overheads have overrun the standards set. These variances are analyzed for their causes
and corrective action is determined by management.
 Actual costs
The actual cost is the amount that a company pays to meet the expenses for the current year, or of the
previous years. Mostly these are the costs that go into accounting to determine the profit or loss for a
business.
1.4 The use of linear, curvilinear and step functions and how their calculations are used to analyze cost
behavior

Cost behavior patterns

There are four basic cost behavior patterns: fixed, variable, mixed (semi variable), and step which graphically
would appear as below.

Total Total Total Total

$ $ $ $

Units Units Units Units

a) Fixed costs b) variable costs c) mixed d) step costs
(semi variable) costs
Fixed costs
Fixed costs remain constant (in total) over some relevant range of output. Depreciation, insurance, property
taxes, and administrative salaries are examples of fixed costs. Recall that so-called fixed costs are fixed in the
short run but not necessarily in the long run.

9
Variable costs
Variable costs vary (in total) directly with changes in volume of production or sales. In particular, total variable
costs change as total volume changes. Such as Direct materials, direct labor and sales commissions are variable
costs.

Direct labor is a variable cost in many cases. If the total direct labor cost increases as the volume of output
increases and decreases as volume decreases, direct labor is a variable cost. Piecework pay is an excellent
example of direct labor as a variable cost. In addition, direct labor is frequently a variable cost for workers paid
on an hourly basis, as the volume of output increases, more workers are hired.

Mixed costs

Mixed costs have both fixed and variable characteristics. A mixed cost contains a fixed portion of cost incurred
even when the facility is idle, and a variable portion that increases directly with volume. Electricity is an
example of a mixed cost. A company must incur a certain cost for basic electrical service. As the company
increases its volume of activity, it runs more machines and runs them longer. The firm also may extend its hours
of operation. As activity increases, so does the cost of electricity.

A step cost
A step cost remains constant at a certain fixed amount over a range of output (or sales). Then, at certain points,
the step costs increase to higher amounts. Visually, step costs appear like stair steps.
Supervisors’ salaries are an example of a step cost when companies hire additional supervisors as production
increases. For instance, the local McDonald’s restaurant has one supervisor until sales exceed 100 meals during
the lunch hour. If sales regularly exceed 100 meals during that hour, the company adds a second supervisor. The
supervisor costs will remain the same for between 0 – 100 meals served that hour. When meals served are
between 101 – 200, the supervisor cost goes up to reflect 2 supervisors. Step costs will increase by the same
amount for each new cost or step. Step costs are sometimes labeled as step variable costs (many small steps) or
step fixed costs (only a few large steps). In graph form, a step cost would appear as:
4_

Total dollar ($000) 2_

Ꞌ
100 200
Units
Although we have described four different cost patterns (fixed, variable, mixed, and step), we simplify our
discussions in this chapter by assuming managers can separate mixed and step costs into fixed and variable
components using cost estimation techniques.

10
Many costs do not vary in a strictly linear relationship with volume. Rather, costs may vary in a curvilinear
pattern—a 10% increase in volume may yield an 8% change in total variable costs at lower output levels and an
11% change in total variable costs at higher output levels. We show a curvilinear cost pattern below.

Total variable costs

Units
1.5 The concepts of cost units, cost centers and profit centers
Cost units
A cost unit is one individual unit of what a business produces product or service in relation to which costs are
separately measured, such as a university student, hospital patient, hotel room, car manufacturer vehicles…etc.
Cost Centers
A cost center is a reporting unit of a business that is responsible for costs incurred. An example of a cost center
is the maintenance department of a business, where its manager is only rated on the amount of costs incurred to
maintain facilities and equipment at a predetermined level. Similarly, the accounting, finance, information
technology, and human resources departments are all treated as cost centers.
Profit Centers
A profit center is a reporting unit of a business that is responsible for profits generated. An example of a profit
center is a subsidiary, which is responsible for the amount of sales generated, as well as all costs incurred.
Similarly, a country division is also treated as a profit center, as may a product line.

Comparing Cost Centers and Profit Centers

The main difference between the two is that a cost center is only responsible for its costs, while a profit
center is responsible for both its revenues and costs. Another difference is that cost centers tend to be
organizationally simple, while profit centers are more likely to have a complex structure. Both concepts
are used in a business where senior management wants to drive responsibility down into the
organization.

11