Cost & Management Accounting

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Part –II

Management Accounting

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MANAGEMENT ACCOUNTING

•• Management Accounting is the process within

Management Accounting is the process within

an organization that provides information used

by managers in planning, implementing, &

controlling the organization’s activities.

•

• The process includes the identification,

The process includes the identification,

measurement, accumulation, analysis,

preparation, interpretation & communication of

the information needed by management to

perform its functions.

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Managerial Accounting and Financial

Accounting

(4)

Little Insight to Management

Accounting

•• MM..AA. . pprroovviiddeess historical & estimated information on full costs &historical & estimated information on full costs &

components of full costs structured by responsibility centers

components of full costs structured by responsibility centers toto support the measurement & control purpose of management support the measurement & control purpose of management accounting information;

accounting information;

•• In In MaMananagegemement nt AAccccouountntining,g, ‘COST’‘COST’ is defined differentlyis defined differently depending on the purpose;

depending on the purpose; •

• thathat acct accouountinting nung numbmberers are as are apppproroxiximamatitionons;s;

•

• thathat rart rarely ely thethey pry proviovide ede exacxactly tly the ithe infonformarmatiotion neen neededded;;

•

• thathat mut much mch more ore thathan acn accoucountinting ing infonformarmatiotion is n is neeneeded ded inin

solution of a problem; &

•

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COST ESTIMATION & MANAGEMENT

•

• _COST:_COST: _{Resources sacrificed or forgone to achieve a}_{Resources sacrificed or forgone to achieve a}

specific objective. Usually measured as the monetary specific objective. Usually measured as the monetary amount that must be paid to acquire goods & service. amount that must be paid to acquire goods & service. •

• COST OBJECT:COST OBJECT: Any activity or item for which a separateAny activity or item for which a separate measurement of cost is desired. Any change made in

measurement of cost is desired. Any change made in any of the cost drivers will cause a c

any of the cost drivers will cause a change in the totalhange in the total cost.

cost. •

• Expl.:Expl.: No of units produced, No. of set-ups, No.of No of units produced, No. of set-ups, No.of itemsitems distributed etc.

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Flow of Manufacturing Activities

Raw Materials Raw Materials Beginning Inventory Beginning Inventory Raw Materials Raw Materials Purchases Purchases Goods in Process Goods in Process Beginning Inventory

Beginning Inventory Finished GoodsFinished Goods Beginning Inventory Beginning Inventory Raw Materials Used

Raw Materials Used Direct Labour Used Direct Labour Used Materials Activity Materials Activity Materials Activity Materials Activity (raw materials) (raw materials) (raw materials) (raw materials) inancial Reports

inancial Reports Raw MaterialsRaw Materials Ending Inv. Ending Inv. (balance sheet) (balance sheet) Production Activity Production Activity Production Activity Production Activity (goods in process) (goods in process) (goods in process) (goods in process) Goods in Process Goods in Process Ending Inv. Ending Inv. (balance sheet) (balance sheet) Finished Goods Finished Goods Finished Goods Finished Goods Ending Ending Inv.Inv.Inv.Inv.

(balance sheet) (balance sheet) (balance sheet) (balance sheet) Cost of Goods Cost of Goods Cost of Goods Cost of Goods Sold (income Sold (income Sold (income Sold (income statement) statement) statement) statement) Marketing Activity Marketing Activity Marketing Activity Marketing Activity (finished goods) (finished goods) (finished goods) (finished goods) Goods Goods Manufactured Manufactured Factory Overhead Factory Overhead Used Used

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COST SYSTEM

•• _{A costing system accounts for costs}_{A costing system accounts for costs in two basic}_{in two basic} stages –

stages – Accumulation & then assignment/ allocation.Accumulation & then assignment/ allocation. 1

1.. CCoosst t AAccccuummuullaattiioonn:: Collection of cost data in anCollection of cost data in an

organized way by means of an accounting system – organized way by means of an accounting system – eg. Raw materials used, fuel consumed, labour

eg. Raw materials used, fuel consumed, labour payment etc.

payment etc. 2

2.. CCoosst At Allllooccaattiioonn:: After accumulation, cost systemAfter accumulation, cost system allocates or traces the cost to

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Cost Allocation

Direct vs. Indirect Costs

•

• Direct Costs

Direct Costs

of a cost object are related to

the particular cost object & can be traced

to it in an economically feasible (cost

effective) way.

•

• Eg.:

Eg.:

Cost of can or bottle is a direct cost of

a soft drink producer.

•

• _{‘Cost Tracing’}

_{‘Cost Tracing’}

_{is used to describe the}

assignment of direct cost to particular cost

object.

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Indirect Cost

•

• Indirect costs

Indirect costs

of a cost object are related

to the particular cost object but can not be

traced to it in a cost effective way.

•

• _Eg.:

_Eg.:

_{Cost of Quality – Control personnel}

conducting tests on multiple soft-drink

products.

•

• _{‘Cost Allocation’}

_{‘Cost Allocation’}

_{is used to describe the}

assignment of indirect costs to

assignment of indirect costs to particular

particular

cost object.

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Cost Allocation

M

Maaiinntteennaannccee FFaaccttoorryy Accounting Accounting Electricity Electricity Machining Machining Department Department Assembly Assembly Department Department Stage 1 Stage 1 Service Departments Service Departments Stage 2 Stage 2 J Joob b 223366 JJoob b 223377 JJoob b 223388

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Elements of Cost

M

Maatteerriiaalls s LLaabboouur r OOtthheer r EExxppeennsseess

Direct

Direct IndirectIndirect DirectDirect IndirectIndirect

Indirect Indirect OVERHEADS OVERHEADS Production or Production or Works Overhead Works Overhead

Office & Administrative Office & Administrative Overhead Overhead Selling & Selling & Distribution Distribution Overhead Overhead COST COST

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Statement of Cost

Direct Material

(+)

(+) Direct Direct Labour Labour

PRIME COST

(+)

(+) Factory Factory OverheadsOverheads

WORKS/FACTORY/

MANUFACTURING COST

(+)

(+) Office & AdministrativeOffice & Administrative

Overheads Overheads COST OF PRODUCTION COST OF PRODUCTION (+ (+)) SeSellllining & Dig & Diststriribubutitionon Overheads Overheads COST OF SALES COST OF SALES

“Factory overheads’ are not expenses – they a

“Factory overheads’ are not expenses – they are part of Inventoriablere part of Inventoriable

cost & will funnel into the expense stream

cost & will funnel into the expense stream only when the inventoriableonly when the inventoriable

costs are released as ‘COGS’.

Inventoriable Costs/ Inventoriable Costs/ Unexpired Costs/ Unexpired Costs/ Manufacturing Cost Manufacturing Cost Period Costs/ Period Costs/ Expired Costs/ Expired Costs/

Non- Manufacturing Expenses

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Cost Classifications

•• Costs can be classified by:

Costs can be classified by:

–

_Relevance

–

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Costs Classification

by Relevance

•

_Relevant

–

_{If costs influence a decision}

•• _{Costs that are applicable to a particular decision.}_{Costs that are}_{Costs that are}_{Costs that are}_{applicable to a particular decision.}_applicabl_applicabl_{e to a}_{e to a}_{particular decision.}_{particular decision.} •• _{Costs that should have a}_{Costs that should have a bearing on which}_{Costs that should have a bearing on which}_{Costs that should have a bearing on which}_{bearing on which}

alternative a manager selects.

alternative a manager selects. alternative a manager selects.

•• _{Costs that are avoidabl}_{Costs that are}_{Costs that are}_{Costs that are}_avoidable._avoidabl_avoidabl_e._e._e.

•• _{Future costs that differ between alternatives.}_{Future costs that}_{Future costs that}_{Future costs that}_{differ between alternatives.}_{differ between alternatives.}_{differ between alternatives.}

•

_Irrelevant

–

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Costs Classification

by Relevance

•

• Sunk Costs

Sunk Costs

–

– All costs incurred in the past that cannot be changed byAll costs incurred in the past that cannot be changed by any decision made now or in the future.

any decision made now or in the future. –

– should not be considered in decisions.should not be considered in decisions. –

– IrrelevantIrrelevant –

– Example:Example: You bought an automobile that costYou bought an automobile that cost

Rs.30,000 two years ago. The Rs.30,000 cost is sunk Rs.30,000 two years ago. The Rs.30,000 cost is sunk because whether you drive it, park it, trade it, or sell it, because whether you drive it, park it, trade it, or sell it, you cannot change the Rs.30,000 cost.

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Costs Classification

by Relevance

•

Out-of-pocket costs

–

_{require future outlays of cash}

–

_{associated with a particular decision}

–

_{relevant for future decisions}

–

_Example:

_{Considering the decision to take a}

vacation or stay at home, if you choose a

vacation, you will only have travel costs

(out-of-pocket costs).

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Costs Classification

by Relevance

•

• _{Opportunity Costs}

_{Opportunity Costs}

–

– The potential benefit that is given

The potential benefit that is given up when one

up when one

alternative is selected over another.

–

_Example:

_{If you were not attending college or}

university, you could be earning

Rs.Rs.

25,000 per

year. Your opportunity cost of attending

college or university for one year is

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Costs Classification by Behavior

•

• Cost behavior refers toCost behavior refers to

–

– how a cost will react to changes in the level of business activity.how a cost will react to changes in the level of business activity.

•

• Fixed costsFixed costs

–

– Do not change when activity changes. Do not change when activity changes. Remains fixed in total for aRemains fixed in total for a given period of time despite wide changes in

given period of time despite wide changes in the related level of the related level of total activity or volume (within the

total activity or volume (within the relevant rangerelevant range).).

These are period costs i.e. Lease rental, Insurance of These are period costs i.e. Lease rental, Insurance of factory buildings etc.

factory buildings etc. •

• Variable costsVariable costs

–

– Change in proportion to changes in the volume of Change in proportion to changes in the volume of activity. Theseactivity. These are basically product costs i.e. Direct Material Cost, Direct Labour are basically product costs i.e. Direct Material Cost, Direct Labour Costs, power, repair etc.

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Total variable costs change when activity changes.

Variable costs per unit do

Variable costs per unit do not change as activity

not change as activity

increases.

Variable Costs

Volume of activity Volume of activity T T o o t t a a l l v v a a r r i i a a b b l l e e c c o o s s t t s s Volume of activity Volume of activity V V a a r r i i a a b b l l e e c c o o s s t t s s p p e e r r u u n n i i t t

(20)

Variable Cost Example

•• Consider the case of Manufacturing plant

Consider the case of Manufacturing plant

of Maruti at Gurgaon.

•• Assume that Maruti buys a steering wheel

Assume that Maruti buys a steering wheel

at Rs.3,000 for each of

at Rs.3,000 for each of its Swift lxi model

its Swift lxi model

Vehicle

•• If Maruti produces 2,000 Swift-Lxi, total

If Maruti produces 2,000 Swift-Lxi, total

cost of steering wheels would be

Rs.60,00,000.

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Variable Costs Example

0

1

2

3

4

5

0

1

2

3

4

5 Rs240 –

Rs240 –

Rs180 –

Rs120 –

Rs60 –

–– –– –– ––

Volume

(Thousands Swift cars)

TT oo ttaa ll VV aa rrii aa ((00 00 ’’00 00 00 ))

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Volume of Activity Volume of Activity Volume of Activity Volume of Activity FF iixx ee dd cc oo ss ttss pp ee rr uu nn iitt F F i i x x e e d d c c o o s s t t s s p p e e r r u u n n i i t t Volume of Activity Volume of Activity Volume of Activity Volume of Activity TT oo ttaa ll ffii xx ee dd cc oo ss ttss T T o o t t a a l l f f i i x x e e d d c coo s s t t s s

•• Total fixed costs remain unchangedTotal fixed costs remain unchangedTotal fixed costs remain unchangedTotal fixed costs remain unchanged

when activity changes within a relevant range.

when activity changes within a relevant range. when activity changes within a relevant range. •• Fixed costs per unit decline as activity increases.Fixed costs per unit decline as activity increases.Fixed costs per unit decline as activity increases.Fixed costs per unit decline as activity increases.

Fixed Cost

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Fixed Costs Example

Plant leasing cost is Rs.200,00,000 for its

Plant leasing cost is Rs.200,00,000 for its Gurgaon plant for a designatedGurgaon plant for a designated

range of number of vehicles assembled during a month.

0

1

2

3

4

5

0

1

2

3

4

5 Rs400 –

Rs400 –

Rs300 –

Rs200 –

Rs100 –

–– –– –– ––

Volume

(Thousands

of

vehicles)

T T o o t t a a l l F F i i x x e e d d C C ((00 00 ’’00 00 00 ))

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Relevant Range...

–

is a band of volume in which a specific

relationship exists between cost and

volume.

••

Outside the relevant range, the cost either

increases or decreases.

••

A fixed cost is fixed only within a given

relevant range and a given time span.

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Relevant Range

F F i i x x e e d d C C o o s s t t s s

Volume in Units

160,000 –

120,000 –

80,000 –

40,000

0

0 5,000 10,000

5,000

10,000 15,000

15,000 20,000

20,000 25,000

25,000

–– –– ––

Relevant Range

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Relevant Range – Step Cost

•

• Step-Wise Costs

Step-Wise Costs

–

– remain fixed over limited ranges of volumes butremain fixed over limited ranges of volumes butremain fixed over limited ranges of volumes butremain fixed over limited ranges of volumes but

increase by a lump

increase by a lump sum when volume increases beyondsum when volume increases beyond

increase by a lump

increase by a lump sum when volume increases beyondsum when volume increases beyond maximum amounts.

maximum amounts.

maximum amounts. maximum amounts. –

– Example:Example:_Example:_Example: additional production supervisors must additional productioadditional productioadditional production supervisors must ben supervisors must n supervisors must bebebe

added when another shift is

added when another shift is added.added.

added when another shift is

added when another shift is added.added.

SS uu pp ee rrvv iiss oo rryy SS aa llaa rrii ee ss S S u u p p e e r r v v i i s s o o r r y y S S a a l l a a r r i i e ess Production Volume Production Volume Production Volume Production Volume

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Mixed Cost

•

• _{Semi- fixed/ Semi-variable costs}

_{Semi- fixed/ Semi-variable costs}

–

– contain a combination of fixed and variable costs.contain a combination of fixed and variable costs.contain a combination of fixed and variable costs.contain a combination of fixed and variable costs.

Variable Variable Variable Variable Sales Commissions Sales Commissions Sales Commissions Sales Commissions Sales Sales Sales Sales T T o o t t a a l l C C o o m mpp e e n n s s a a t t i i o o n n T

T o o t t a a l l m m i

i x x e e d d c c o o s s t t T

T o o t t a a l l m m

i

i x x e e d d c c

o o s s t t Fixed Fixed Fixed Fixed Monthly salary Monthly salary Monthly salary Monthly salary

(28)

Mixed Costs Example

•• A

A mixed cost

mixed cost

is part variable and part

fixed (as most of the costs are neither

perfectly fixed, nor perfectly variable).

•• Assume a department of a company has

Assume a department of a company has

fixed costs of Rs.50 per month (Rs.600

per year).

•• There are also variable costs of Rs.3 per

There are also variable costs of Rs.3 per

hour.

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Mixed Costs Example

0

125 125 250

250 375

375 500

500 625

625 Rs2,475 –

Rs2,475 –

Rs2,100 –

Rs1,350 –

Rs600 –

–– –– –– ––

Volume (hours)

TT oo ttaa ll CC oo ss ttss Variable Variable Cost Cost Fixed Fixed Cost Cost

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Estimating Cost – Volume

Relationship

•• Several methods are used to estimate the

Several methods are used to estimate the

cost volume relationship, i.e. to arrive at

the total fixed cost & the unit variable cost

in the equation –

•

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1. Judgment Method

•• Using judgment in deciding how much of cost Using judgment in deciding how much of cost of eachof each item or category will vary with volume & what will be the item or category will vary with volume & what will be the amount of fixed cost.

amount of fixed cost. •• Appropriate where;Appropriate where;

•• Cost estimation for a sCost estimation for a situation where historical data areituation where historical data are irrelevant

irrelevant viz,viz, a proposal to introduce a new product witha proposal to introduce a new product with a new process.

a new process.

•• The reliability of the results depends on The reliability of the results depends on the experience &the experience & skill of the estimator.

skill of the estimator.

•• Also known asAlso known as ‘Account-by-Accoun‘Account-by-Account t Method’Method’ as theas the analyst considers each account in the cost structure & analyst considers each account in the cost structure & judges whether the costs in

judges whether the costs in that account are that account are variable,variable, fixed or

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2. High – Low Method

1.

1. EsEstitimamate tte tototal cal costosts at s at eaeach tch two wo vovolumlume lee levevelsls, wh, whicichh

identifies two points on the line – the upper & lower limits identifies two points on the line – the upper & lower limits of the relevant range are selected for the purpose.

of the relevant range are selected for the purpose. 2.

2. SuSubtbtraract tct tototal cal cosost at t at lowlower ver voluolume fme frorom tm the hhe higigher her one one && also subtract the corresponding lower volume from the also subtract the corresponding lower volume from the higher.

higher. 3.

3. DiDivivide tde the dhe dififfeferenrence ice in con cost bst by diy diffffererencence in e in vovolumlume toe to arrive at the Unit Variable Cost (UVC).

arrive at the Unit Variable Cost (UVC). 4.

4. MuMultltipliply ey eitither her of of the the vovolumlumes es by Uby UVC VC & s& subtubtraract ct ththee result from the total cost at that volume to arrive at the result from the total cost at that volume to arrive at the Fixed Cost.

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3. Scatter Diagram

•• Make a diagram in which actual costs recorded in pastMake a diagram in which actual costs recorded in past periods are plotted (on the vertical axis) against the

periods are plotted (on the vertical axis) against the volume of levels in those periods (

volume of levels in those periods ( on the horizontalon the horizontal axis).

axis).

•• Data on costs & volumes for each of Data on costs & volumes for each of the precedingthe preceding several months may be used for the purpose.

several months may be used for the purpose. •

• Draw a line that best fits the observation by visualDraw a line that best fits the observation by visual

inspection of the plotted points.

•

• The FC & TVC values are then determined by readingThe FC & TVC values are then determined by reading

the values for any two points on the line and using the

High-Low Method discussed previously.

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Scatter diagram with High-Low Method of

Cost Estimation

Ind

Indireirectct1,451,4566

Labour Labour Costs 710 Costs 710 Rs. Rs. 46 96 46 96 Machine Hours Machine Hours x x x x xx x x xx x x xx x x Va

Variariable cble costost = Cha= Change inge in cosn cost / Chat / Change inge in voln volumeume =

= (Rs1,456 (Rs1,456 – – Rs.710) Rs.710) / / (96 (96 - - 46) 46) = = Rs.14.92Rs.14.92 per MH per MH F

Fiixxeed d ccoosstt = M= Miixxeed d ccoosst t aat t hihiggh h ppoioinnt t - - vvaarriaiabblle e ccoosstt = = Rs1,456 Rs1,456 - - (96 (96 x x Rs.14.92)Rs.14.92) Rs.23.68 Rs.23.68 weekweek Cost function = Cost function = Rs(23.68 + 14.92) Rs(23.68 + 14.92)

per machine hour

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Regression Analysis Method

•• Regression analysis is a statistical method that Regression analysis is a statistical method that measuresmeasures the average amount of change in t

the average amount of change in the dependent variablehe dependent variable (x) that is associated with a unit change in one or

(x) that is associated with a unit change in one or moremore

independent variable (s) independent variable (s) •

• Simple linear regressionSimple linear regression - one - one independeindependent variablent variable •

• Multiple regressionMultiple regression - more than one independen- more than one independent variablet variable •• Allows for the evaluation of the quality of the cost functionAllows for the evaluation of the quality of the cost function

–

– Coefficient of determination (R-Squared) measures theCoefficient of determination (R-Squared) measures the goodness of fit of the line to the

goodness of fit of the line to the underlying dataunderlying data –

– t-value measures the potential error of t-value measures the potential error of the estimatedthe estimated variables

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4. Linear Regression

Method of Least Square

•• _{This approach provides two}_{This approach provides two mathematical properties}_{mathematical properties} that are missing in all previous methods.

that are missing in all previous methods. •

• Σy = na + Σy = na + b Σx…………..(1)b Σx…………..(1)

•

• _{Σxy = a Σx + b Σx2 ……..(2)}_{Σxy = a Σx + b Σx2 ……..(2)}

•• Where Σy = Total cost; Where Σy = Total cost; Σx = Total VolumeΣx = Total Volume •• a= Total Fixed cost;a= Total Fixed cost;

•• b= Variable cost per unit;b= Variable cost per unit; •• n= No. of time periodn= No. of time period

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Nonlinearity Cost Function

Nonlinear cost function

•• a cost function in which the graph of total ca cost function in which the graph of total costs versus aosts versus a single cost driver does not form a straight line within the single cost driver does not form a straight line within the relevant range relevant range Time Time Cumulative Cumulative Total Volume Total Volume Nonlinear Nonlinear Cost Function Cost Function (Learning Curve) (Learning Curve)