PAPER NO: 5
CPA SECTION 2
KASNEB STUDY TEXT
5.1 Nature and purpose of cost and management accounting
- The nature of cost accounting and costing terms
- The role of cost accounting in management
- The purposes of cost accounting information
- Scope of cost accounting
- Meaning of management accounting, scope, limitations, applications
- Relationship between cost, financial and management accounting
- Selection of an ideal cost accounting system
5.2 Cost classification
- Definition and purpose of cost classification
- Methods of cost classification: nature/elements of manufacturing costs; functional classification; behavioural classification; controllability; time; financial accounting; identification with inventory; for decision making
5.3 Cost estimation
- Meaning of cost estimation
- Methods of estimating cost; non-mathematical methods like engineering method, accounts analysis method and high-low method; mathematical methods like scatter graph method, OLS regression method (simple linear regression only)
5.4 Accounting, for material, labour and overheads
- Accounting for materials and inventory; material cost records, purchasing procedures, receipt and issues of material, methods of valuing material issues, inventory control procedures; economic order quantity (EOQ) and economic batch quantity(EBQ) models and back flush
- Accounting for labour: Methods of labour remuneration, labour control procedures, maintenance of labour records
- Accounting for overheads: Types of overheads, manufacturing, distribution and administration, service departmental cost allocation and apportionment, overheads analysis, overhead absorption rates, over or under absorption
5.5 Cost bookkeeping
- The flow of costs in a business enterprise
- Cost bookkeeping- interlocking and integrated ledger systems
5.6 Costing methods
- Job order costing
- Batch costing
- Process costing (including work in progress; joint and by-products)
- Service costing
- Unit costing
5.7 Marginal and absorption costing
- Distinction between marginal and absorption costing
- Valuation of products under marginal and absorption costing
- Preparation of marginal and absorption statements; cost of production and profit determination
- Applications of marginal costing: break-even analysis and charts (single product)
- Simplified decision problems; accept or reject, special order, dropping a product, make or buy
- Operating statements
5.8 Activity based costing
- Meaning of ABC
- Types of activities
- Overhead absorption rates
- Incomes statement
5.9 Budgeting and budgetary control
- Nature and purposes of budgets
- Preparation of budgets; master budgets, functional (department budgets, cash budgets), proforma financial reports (income statements and balance sheets)
- Purpose of budgetary control; operation of a budgetary control system, organisation and coordination of the budgeting function
- Distinction between budgeting and budgetary control in the private and public sectors
5.10 Standard costing
- Types of standards
- Principles of setting standards
- Standard cost card
- Behavioural aspects of standard costing
- Generation of standard cost information
- Materials, labour and overheads variances; price ,efficiency mix and yield variances
5.11 Cost management
- Value chain-research and development; design; production; marketing distribution; customer care
- Just in time (JIT)
- Use of computers in costing; job costing, inventory management, labour costing, cost entre analysis, coding, budgeting and decision making
5.12 Emerging issues and trends
NATURE AND PURPOSE OF COST AND MANAGEMENT ACCOUNTING
Cost accounting is defined as, “That part of management accounting which establishes budgets and standard costs, and the actual costs of operations, processes, departments or products and the analysis of variances, profitability or social use of funds.”
Costing : Costing is defined as the technique and process of ascertaining costs.
This involves participation in and with management to ensure that there is effective:
- Formulation of plans to meet objectives (long-term planning)
- Formulation of short-term operation plans (budgeting/profit planning)
- Corrective action to bring future actual transactions into line (financial control)
- Recording of actual transactions
Definition – Cost classification may be defined as the arrangement of cost items in a logical sequence having regard to their nature and purpose to be fulfilled. Costs are classified according to the cost objectives. Cost objective is the activity for which a separate measure of cost is desired. They include, cost stock valuation, cost for decision-making and cost for control purposes. Cost classification is important as management accountants apply it when preparing budgets and carrying out sensitivity analysis.
Elements of cost
All expenditure can be classified into three main groups – labour, materials and expenses. Each of the expenses may be subdivided into one of two categories:
- Items directly applicable to the product, i.e. direct.
- Items which cannot be directly applied to the product, i.e. indirect.
The total of indirect materials, indirect labour and indirect expenses is called overhead
Common terms used
Cost driver – Is any activity that causes a cost to be incurred e.g. labor hours, level of output, etc.
Correlation – Is the degree of association between variables
Coefficient of determination – Measures how much of the variation in the dependent variable is explained the variation in the independent variable.
Regression line – Is a line fitted to an array of plotted points; may also be referred to as line of best fit
Cost estimation – May be defined as a study which attempts to predict the relationship between costs and the activity level or cost driver1 that causes those costs based on an analysis of historical costs. In other words, cost estimation occurs when an individual attempts to measure historical costs in order to predict future costs.
To achieve the measurement, it is necessary to separate cost into their fixed and variable cost elements. Semi variable costs can be separated into their fixed and variable components using scatter diagram approach, high-low method or regression analysis.
In this topic, we shall deal with linear cost relationships and equations. A linear equation is an expression of the relationship between variables, the independent and the dependent variables.
The cost estimating function for linear relationships is;
Y = a + bX
Analyzed as Total cost = Fixed cost + Variable cost
Y – Represents the dependent variable or the total cost
A – Represents fixed cost component of the total cost (Constant amount)
Bx – Represents the variable costs component of the total cost
b – Represents the unit variable cost (this is the gradient of the equation)
x – Represents independent variable or the output level
ACCOUNTING FOR LABOUR, MATERIAL AND OVERHEADS
Material is any substance (Physics term) that forms part of or composed of a finished product. i.e material refers to the commodities supplied to an undertaking for the purpose of consumption in the process of manufacturing or of rendering service or for transformation into products. The term ‘Stores’ is often used synonymously with materials, however, stores has a wider meaning and it covers not only raw materials consumed or utilized in production but also such other items as sundry supplies, maintenance stores, fabricated parts, components, tools, jigs, other items, consumables, lubricants……etc. Finished and partly finished products are also often included under the term ‘Stores’. Materials are also known as Inventory. The term Materials / Inventory covers not only raw materials but also components, work-in-progress and finished goods and scrap also.
COST BOOK KEEPING
COST ACCOUNTING RECORDS, LEDGERS AND COST STATEMENT COST ACCOUNTING RECORDS, LE COST STATEMENT
In the preceding sections, we have dealt with the basic concepts of costs and the various elements of costs. We have also seen the different steps followed in determination of cost of a product or rendering a service. Treatment of various costs has been discussed at length. You are now very well aware that the term cost has wide connotations and would not mean anything in isolation. Costs must be understood if they are to be controlled. Measurement of costs is the first step in the process of control simply because you cannot control unless you measure. Measurement of cost would mean different when applied to different industries.
The cost has to be measured with respect to the cost centers first and then at a broader level with respect to the cost unit. The journey towards the aim of determining cost of a product or service may take various routes. But the logic is same i.e. collect all relevant costs in the process of converting raw material into finished product and accumulate the total costs.
To put in simple words, to generate any product or service, resources are needed called as inputs. Theses inputs are used in a process of conversion. The end result is the output which could either be a product or a service. The resources consume costs. While determining total cost of resources, the costs of all resources used (directly or indirectly) in the process are accumulated. This requires establishing the relationship between the resource and the product or service.
Material cost is the significant constituent of the total cost of any product. It constitutes 40% to 80% of the total cost. The percentages may differ from industry to industry. But for manufacturing sector the material costs are of greatest significance. Inventory also constitutes a vital element in the Working Capital. So it is treated as equivalent to cash. Therefore the analysis and control on Material Cost is very important.
Costing is the technique and process of ascertaining costs. In order to do the same, it is necessary to follow a particular method of ascertaining cost. Different methods of costing are applied to different industries depending upon the type of manufacture and their nature. Broadly the costing methods are classified into the following:
- Specific Order Costing (Job or Terminal Costing)
- Operation Costing or Process or Period Costing
Specific Order Costing: Specific order costing is the category of basic costing methods applicable where the work consists of separate jobs, batches or contracts each of which is authorised a specific order or contract. It includes job costing consisting batch costing and contract costing.
Job Order Costing:
Industries which manufacture products or render services against specific orders as distinct from continuous production for stock or sales use the job costing or job order method of cost accounting. The method is also known under various other names, such as specific order costing, production order costing, job lot costing or lot costing. Every order in job costing is separate and it is not essential that the same manufacturing operations be carried out or the same materials be utilized in respect of each. However, a number of identical orders or identical products may be combined together to form lots or batches, each such lot or batch constituting a job order. In the job costing system, an order or a unit, lot, or batch of a product may be taken as a cost unit, i.e. a job.
MARGINAL AND ABSORPTION COSTING
Marginal Cost is defined as “the amount at any given volume of output which aggregate costs are changed if the volume of output is increased or decreased one unit.” Marginal Cost also means Prime Cost plus Variable Overheads. Marginal Cost is a constant ratio which may be expressed in terms of an amount per unit of output. On the other hand, fixed cost which is not normally traceable to particular unit denotes a fixed amount of expenditure incurred during an accounting period. Fixed cost is, therefore, also called time cost, period cost, standcost, capacity cost, or constant cost. Variable cost or marginal cost is also termed as direct cost, activity cost, volume cost or out-of-pocket cost.
From the above definition and analysis of marginal cost, we can understand that is the cost which varies according to the variations in the volumes of output. However, definition marginal cost is the change in the total cost for addition of one unit. It is to be noted that for an economist marginal cost and variable cost would be different. But for an accountant both marginal cost and variable cost are same and are interchangeably used. Therefore, for our study, we use marginal cost and variable cost synonymously.
ACTIVITY BASED COSTING
This is a new approach used to determine overheads. The traditional approach of overhead absorption assumes that overheads will be volume related, that is, the more the units produced the more the overheads are incurred. However, not all overheads are volume related and this leads to another determination of costs and profits and since not all costs are related to volume or output there could be a wrong valuation of profits if traditional approach is applied.
Therefore, ABC system is a costing technique where overhead costs will be charged to products on the basis of activities carried out instead of relying on the cost centers in determining overhead absorption rate. The cost center determination of overhead absorption rate (OAR) will be calculated using various activities.
BUDGETING AND BUDGETARY CONTROL
The literary meaning of the word Budget is a statement of income and expenditure of a certain period. In principle, the meaning is same in the context of business also. An individual will have his own budget, a family, a local authority, state and country etc. All will have their respective budgets. So also the business concern must have its budget so as to attain their objectives.
CIMA defines a budget as, “A budget is a financial and/or quantitative statement, prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective.”
Features of Budget
An analysis of the above definition reveals the following as features of the budget.
- A Budget must be expressed either in quantitative form i.e., the number of units of different products or it may be expressed in rupees of each product or it may be quantitative and financial form i.e., the number of units and rupees of each product etc.,
STANDARD COSTING AND VARIANCE ANALYSIS
Standard Cost is defined as “the predetermined cost that is calculated at the management’s standards of efficient operations and the relevant necessary expenditure”.
From this we understand that it is the cost calculated when all the people working in the organisation to their utmost, the expenditure incurred for producing the product can be taken as standard cost. The optimum efficiency cannot at all-time exist. Therefore, optimum efficiency is assumed and that is why standard cost is called assumed cost. Further, all the inputs of cost scientifically analysed using so many industrial engineering techniques such as work measurement, method study, time and motion study, merit rating, job evaluation and other scientific techniques, it can also be called as Scientific Cost.
A value chain is used to define the combination of all the activities and resources needed for generating products and services. The value chain often consists of several operators (manufacturing industry, wholesale trade, retail trade, customer, etc.) The value chain ends with the customer.
There are various types of value chain:
- Simple value chain: The value chain describes the full range of activities which are required to bring a product or service from conception, through the different phases of production (involving a combination of physical transformation and the input of various producer services), delivery to final consumers, and final disposal after