E-BOOK COST&MANAGEMENT ACCOUNTING

CHAPTER 1

INTRODUCTION
TO

COST ACCOUNTIING

Learning
Outcomes

At the end of the chapter, the
students should be able to:

Define accounting, financial

accounting, cost and

management accounting

Differentiate between cost

accounting and financial

accounting

Discuss the objective of cost

accounting

Explain the basic cost terms: cost,

cost unit and cost center

1

1. INTRODUCTION

Definition

Accounting involved with the process of classifying, recording and summarizing
of transactions and business events in monetary terms, and interpreting the results
to interested parties (users of financial statements) to enable them to make
decision.

Financial Accounting rules require that we match costs with revenues to calculate
profit by making accounts of the company and using those accounts to prepare
financial statements and reports for the users who are not part of management.

Cost Accounting is concerned with cost accumulation for inventory evaluation to
meet the requirements of external reporting and internal profit measurements. It is
an approach to evaluating the overall costs that are associated with conducting
business.

Management Accounting is an analysis of financial and cost accounting for
management of business or different plans and policies. It relates to the provision
of appropriate information for decision-making, planning, control and
performance evaluation.

Cost accounting differs from management accounting in a sense that it relates
basically with all those factors that will be determining the cost of company where
as in management accounting managers will be concerned with not only costs but
also profitability of company and assessment of whether cost and profit targets are
achieved, if not then assessment of its reasons.

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Users of Accounting Information
Users of accounting information are divided into two parties:
Internal parties, such as managers, owners, and employees within the
organization.
External parties, such as shareholders, creditors, investors and regulatory
agencies, outside the organization.

Figure 1: Users and Uses of Accounting Information

USERS THE USES

INTERNAL USERS

1. Owners of Interested in the profits earned from their investment in the
Business business, the financial position, the financial stability and
the growth of their businesses.
2. Managers Management needs information to guide them in planning,
organising, directing and controlling the organisation and
3. Employees analysing the operations the organisation.
Interested in knowing the business ability to progress and
expand. They wanted to have a steady employment, earning
capacity and any incentives that they can gain if the
business profitable and stable.

EXTERNAL USERS

4. Creditors Interested to know the financial position of the business and

(Suppliers and their ability to pay the amount owing to them.

Bankers)

5. Current and Require the information about the solvency and the

Potential Investors financial position and strength of the business, its present

and future earning capacity and the ability of the manager

in managing the business.

6. Taxing Authorities Interested in the accounting statements and reports of a

(Internal Revenue business especially for the tax purposes.
Service – LHDN)

7. Regulatory Regulatory agencies such as the Securities and Exchange

agencies Commission wants to know whether the company is

operating within prescribed rules.

9. Labour Union Want to know whether the owners have the ability to pay
increased wages and benefits (workers’ welfare).

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2. FINANCIAL ACCOUNTING AND COST &
MANAGEMENT ACCOUNTING

Figure 2: Financial Accounting vs Cost & Management Accounting

Characteristic Financial Accounting Cost and
1. Objective Management Accounting
It provides information regarding the It provides information of
2. Nature financial performance and financial ascertainment of cost to control cost
position of the business. and decision-making.
3. Recording of It classifies, records, presents and It classifies, records, presents, and
data interpret transactions in term of interprets material, labor and
money. overheads cost in a significant
4. Users of manner.
information Time dimension: It records historical Time dimension: It records and
data. presents the estimated data (future
5. Emphasis Precision (Accurateness) of data) by using both historical data and
information is required. predetermined costs.
6. Analysis of Timeliness of information is required.
costs and External users: Reports to those Internal users: Reports to those
profits outside the organization owners, inside the organization for planning,
lenders, tax authorities and directing and motivating, controlling
7. Report regulators. and performance evaluation.
frequency Emphasis is on summaries of Emphasis is on decisions affecting the
financial consequences of past future.
8. Presentation activities.
of information It shows the profit or loss of an It provides the details of cost and
organization. profit of each product, process, job,
9. Legal contract, etc.
requirements Financial statements are prepared for Reports and statements are prepared
a definite period, usually a year as and when they are required or
needed (whether daily, weekly or
A set format is used for presenting monthly).
financial information There are no any set formats for
Only summarized data for the entire presenting cost information
organization is prepared. Detailed segment reports about
departments, products, customers, and
Mandatory for external report (for employees are prepared.
public limited company). Not mandatory to produce reports to
external parties.

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3. OBJECTIVES OF COST ACCOUNTING

The Objectives of Cost Accounting

(a) Determining the selling price by identifying the cost to make and sell product
or service.

(b) Controlling cost by using several techniques such as standard costing, and
budgetary control.

(c) Providing information for management decision making.
(d) Ascertaining profit by matching the cost incurred with the revenue for an

activity.
(e) Facilitating the preparation of the financial and other statements required by

the management whether daily, weekly or monthly statements.

The Importance of Product Costing

(a) To prepare the financial statements, management needs a cost of goods sold
amount on the Statement of Profit or Loss and the inventory amount on the
Statement of Financial Position.

(b) For internal needs, management needs product cost information to establish
prices, to compare actual with budgeted figures, etc.

(c) Often outsiders such as insurance companies or government agencies have a
need for product cost information.

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5. BASIC COST TERMS

Cost

The term cost reflects a monetary measure of the resources sacrificed or forgone to
achieve a specific objective, such as acquiring a good or service.

Cost Object

A cost object is any activity for which a separate measurement of costs is desired.
In other words, if the users of accounting information want to know the cost of
something, this something is called a cost object.

For example: Cost of a product, cost of giving service to a patient, cost of
operating a department, cost of an activity.

Figure 3: Examples of Cost Objects

Cost Object Illustration
1. Product A Proton Waja Car
2. Service Airline flight from Alor Setar to Kuala Lumpur
3. Program A business program in UiTM Perlis
4. Department Quality Control Center in a factory
5. Activity The inspection to determine the level of quality for a
product.

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Cost Unit

A cost unit is a quantitative unit of products or services which cost can be
ascertained. In other word, it is a measure of whatever causes the incurrence of a
cost. A change in a cost unit will cause a change in the total cost of a related cost
object.

For example: kilograms of sugar, liters of petrol, the number of miles driven by
sales persons, the number of pounds of laundry cleaned by a hotel, the number of
calls handed by technical support staff at a software company, and the number of
beds occupied in a hospital.

Cost Centers

Cost centers are sections of a business that can be a location, person or item of
equipment which cost may be ascertained or determined/charged. For example: A
location: sales area, departments; A person: salesman, consultants.

Cost centers can be classified into:
(a) Process Cost Center: where a specific process or a continuous sequence of

operations is performed. For example, bakery: mixing, cooking and
packaging department.
(b) Production Cost Center: where production is performed. For example,
furniture manufacturing: machine department, assembly department and
finishing department.
(c) Service Cost Center is a servicing center for other cost centers. For example:
maintenance department.

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CHAPTER 2

ELEMENTS
OF COST &

COST
STATEMENT

Learning Outcomes

At the end of the topic, the
students should be able to:

Define and understand the
elements of cost: materials,
labor and overheads
Classify the costs
Explain about the cost
statement
Discuss the advantages of
preparing a cost statement

Prepare a cost statement

1

1. INTRODUCTION TO ELEMENT OF COST

Cost Accounting is concerned with cost accumulation for inventory
evaluation to meet the requirements of external reporting and internal
profit measurements. It is an approach to evaluating the overall costs
that are associated with conducting business.

By accumulating these three elements of costs, a product cost can be
determined.

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2. MATERIALS

Introduction to Materials

Materials are known as supplies purchased from outside sources which
are used to manufacture products for sale.

Direct Materials

Direct Materials consist of all those materials and supplies that can be
directly identified with a specific product. Direct Material is one of the
prime elements of production cost. Moreover, direct material cost is
considered as a direct cost and traceable in manufacturing a product.

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Characteristics of Direct Materials:

(a) The cost of materials is directly identified with a specific product.
(b) The materials are the main ingredients or components of a product.

Figure 1: Examples of Direct Materials

Type of Production Direct Materials
Cakes Flour, butter, eggs
Furniture Wood, metal, glass, plastics, and rattan
Clothing Fabric

Indirect Materials

Indirect Materials are consumables or supplies that are not readily
identifiable with a specific product or not used as raw material, but
which make the production of a good or service possible, more efficient,
or safer such as cleaning chemicals, disposable tools, protective devices.

Moreover, there are material costs that are not considered direct
materials, and instead are classified as indirect material costs. These
material costs are immaterial and not worth to be traced to a specific
product, or cannot be clearly associated with a specific product.

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Indirect material costs are known as indirect costs and are charged to
overhead accounts. For example, glue and nails used in furniture
making, coloring and flavoring of cake in cake production.

Characteristics of Indirect Materials:

(a) Materials that are not able to specifically identified to a product.
(b) Materials that are used in a product production but the costs are

immaterial.

Figure 2: Examples of Indirect Materials

Type of Production Indirect Materials
Cakes baking soda, baking powder, coloring,
flavoring
Furniture Nail, glue
Clothing Thread, button

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3. LABOR

Introduction to Labor

Labor is one of the elements of cost that contribute to a product cost. It
is the physical and/or mental effort expended in the manufacture of a
product or a provision of a service to transform raw material into
finished products. Meanwhile, labor cost is the cost (salary and wages)
of payment to the workers for the work done.

It’s vital to separate direct labor costs from other labor costs in order to
accurately calculate total production costs.

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Direct Labor

Direct labor can be specifically associated with the manufacture of a
product, a particular work order, or provision of a service. Direct labor
cost is considered as a direct cost and traceable in manufacturing a
product or a service. It is an element of prime cost of production.

Direct labor in a manufacturing business refers to the work done by
those workers who actually make the product on the production line: to
produce, assemble, inspect, and test the product for each manufacturing
step. Meanwhile for a service business, direct labor is the work
performed by the workers who provide the service directly to the
customers, such as auditors, lawyers, and consultants.

Characteristics of Direct Labor:

Labor is classified as a direct labor when:

(a) Physical Association. There is direct relationship to the specific
product.

(b) Measurability. The labor cost may be measured in monetary value.
(c) Materiality. Labor cost is sufficiently material (significant) in

amount.

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Figure 3: Examples of Direct Labor

Type of Business Example of Direct Labor
Manufacturing
In manufacturing firms, direct labor is the
workers of the production crew that produces
goods, such as:

Machinists / Machine operators
Assembly line operators
Welders

Service When a business provides services, direct
labor is considered to be the labor of those
people who provide services directly to
customers, such as:

Workers in the kitchen of a restaurant
Barbers in barbershop
Lawyers in law firms

Indirect Labor

Labor costs that cannot be physically traced to the creation of products
or service, or that can be traced only at a great cost and inconvenience,
are termed indirect labor.

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Indirect labor includes for instance, the labor costs of janitors,
supervisors, materials handlers, and night security guards in a factory.
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 and treated as part of manufacturing overhead, along
with indirect materials.

In addition, labor that is not directly related to the production such as
administrative workers, salespersons, researchers in Research and
Development departments are also considered as indirect labor. These
indirect labor costs are treated as non-production overheads.

Characteristics of Indirect Labor:

(a) Labor that are not able to specifically identified to a product.
(b) Labor that are not involve in the actual manufacturing process.

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Figure 4: Examples of Indirect Labor

Type of Business Indirect Labor
Manufacturing
Workers in Production area, such as:
Service Supervisors
Security staff
Storekeepers
Factory cleaners

Workers in Non-production area, such as:
Administrative staff
Sales team members
Security staff
Office cleaners

Workers that didn’t provides services
directly to the customer, such as:

Receptionist
Administrative staff
Security staff
Office cleaners

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4. OVERHEADS

Introduction to Overheads

Overheads are defined as costs which cannot be identified directly to a
particular product. It must be shared between products by allocating
and apportioning cost centers and absorbing them into cost units.

Overhead expenses include three general categories of costs: (a)
indirect materials, (b) indirect labor, and (c) all other miscellaneous
expenses (indirect expenses) such as taxes, insurance, depreciation,
supplies, utilities, and repairs.

Indirect Materials

Indirect materials mean materials which are not traceable to the
product being made. Moreover, materials of small value are sometimes
identified as indirect materials. For example: glue used in book
printings, sandpaper used in furniture making oil and grease used in
maintaining machine.

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Indirect Labor/Wages

The wages are paid to employees who are not directly involved in
production. For example: wages paid to cleaners, supervisors,
technician.

Indirect Expenses

Those expenses that incurred for the business as a whole (not direct
expenses). For example: Utilities, rent, insurance.

5. CLASSIFICATION AND TYPES OF COST

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Cost Classification by Function

(a) Production/Manufacturing Costs

Traditional cost accounting systems accumulate product costs as

follows:

RM

Direct Materials (DM) xx

Direct Labors (DL) xx

Direct Expenses (DE) xx

Prime Cost xxx

Production Overheads (POH) xx

Total Production Cost xxxx

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Direct Materials – consist of all those materials that can be identified
with a specific product. It is considered as a direct cost. For example:
flour, sugar and butter for production of cakes; sugar and strawberry
for production of strawberry jam.

Direct Labor – consists of those labor costs that can be specifically
traced to or identified with a particular product. It is considered as a
direct cost. For example, the wages of production operator.

Direct Expense – other costs incurred that can be traced directly to
product, such as rental cost of a special machine for producing a specific
product.

Prime Cost = DM + DL + DE

Production Overheads – consists of all manufacturing costs other than
direct materials, direct labors and direct expenses. It includes all the
indirect costs of materials and labor plus indirect manufacturing
costs. For example: rental of the multi-product factory. Production
overheads cannot be traced directly to products. Therefore, they are
assigned to products using cost allocations (estimation of costs using
activity basis).

Conversion Cost = DL + POH

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(b) Non-Production Costs

Non-production costs are those costs that are not incurred to
manufacture a product.

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Cost Classification by Traceability

Figure 5: Examples of Direct and Indirect Costs.

Cost Object Direct Costs Indirect Costs

1 A business branch Rental of building Rental of head quarter’s

Salaries of branch’s building

workers Head quarter’s

administration costs

2 Purchases Salary of purchases Rental of Office Building

Department department’s Electricity costs of office

workers building

3 Product Wages of production Salary of supervisors

workers Warehouse rental for

Raw materials costs multiple products

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Cost Classification by Behavior

Cost behavior refers to how a cost will react or respond to changes in
the level of business activity. As the level of activity rises and falls, a
particular cost may rise and fall as well; or it may remain constant.

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Variable Cost

The activity can be expressed in many ways, such as units produced,
units sold, miles driven, beds occupied, hours worked and so forth. For
example: direct materials, direct labors. The total variable costs are
linear and the unit variable cost is constant. (Refer to Figure 6).

Figure 6: Graphical Format - Total Variable Cost (TVC)

Production Cost (RM)

TVC

0
Unit Produced (Unit)

Fixed Cost

As the activity level rises and falls, the fixed costs remain constant in
total amount. For example: rent, supervisor salary, salaries of top
management, insurance. The total fixed costs are constant for all levels
of activity whereas the unit fixed costs decrease proportionally with the
increase level of activity, vice versa. (Refer to Figure 7)

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Figure 7: Graphical Format - Total Fixed Cost (TFC)

Warehouse Rental (RM)

RM10,000 Fixed Cost Line (TFC)

Fixed Cost

0
Unit Produced (Unit)

Mixed cost / Semi-Variable Cost

A characteristic of mixed cost that needs to be understood is that we
usually have to separate fixed and variable components of the total
mixed cost (by using High-Low Method). For example: Fixed line
telephone expenses. Line rent normally is fixed for each month. Variable
portion consist units consumed or calls made.

The fixed portion of the mixed cost represents the basic, minimum cost

of just having a service available for use. The variable portion

represents the cost incurred for actual consumption of the service. The

variable element varies in proportion to the amount of service that is

consumed (refer to Figure 8).

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Figure 8: Graphical Format - Semi-Variable Cost

Telephone Cost (RM) Total Cost Line
0 Variable Cost

Fixed Cost Line
Fixed Cost

Unit Consumed

Semi-Fixed or Step-Fixed Cost (refer to Figure 9)

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Figure 9: Graphical Format - Step-Fixed Cost

Total Cost (RM)
2400
1600
800

0 1000 2000 3000 Production Units

6. COST STATEMENT

Introduction to Cost Statement

A cost statement or cost sheet is a breakdown of all costs incurred,
which is comprised of direct and indirect expenses and represents the
various costs incurred at different stages of business operations. It
determines the total cost made by the firm, along with the cost incurred
on each unit of a product or service in a particular period.

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The main objective of preparing a cost statement is to obtain an
accurate product cost. It is also a useful tool for the managers to keep
control over the firm expenses and cost of the products or services.

The Advantages of Cost Statement

(a) It helps to keep track of various components of costs incurred at
different stages and departments

(b) It provides per unit cost of a product or service at every stage of
business operation, which helps the management to analyze and
control such overheads.

(c) It also helps in deciding the selling price of a product or service
based on the cost incurred and profit expected out of it.

(d) The production managers can study the past figures of the firm’s
cost statement to ensure the efficiency of business operations and
for eliminating the non-productive expenses.

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Cost Statement Format

Figure 10: Cost Statement Format

Note:
1. Total Costs consists of production costs and non-production costs.
2. Refer to cost classification by function in order to prepare a cost

statement

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Comprehensive Example

Question

Maya Frozen Enterprise, produce variety of frozen foods for local and
international markets. As an account assistant, you are asked to prepare

the cost statement for the business for the month of October 20X1. The

following information are given:

RM

Raw materials 6,000

Delivery cost of raw material to factory 650

Production operators’ wages 7,000

Wages of cleaners (RM400 was paid for office cleaners) 1,400

Production supervisors’ salary 3,000

Manager’s remuneration 2,600

Depreciation of building (70% for production area) 1,500

Specialized machine rental cost 1,200

Depreciation of office equipment 300

Sales commission 1,700

Utilities (20% for office area) 2,700

Product promotion cost 600

Depreciation of delivery van 400

Other Administrative costs 1,800

Total Cost 30,850

Required:
Prepare a cost statement showing clearly Prime Cost, Total Production
Cost, Administrative Cost and Selling & Distribution Cost.

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Solution:

Workings:

Step 1: Identify the classification of cost according to function.

Classification RM

Raw materials P – DM 6,000

Delivery cost of raw material to factory P – DM 650

Production operators’ wages P – DL 7,000

Wages of cleaners:

Wages of cleaners (office) NP – A 400

Wages of cleaners (factory) P – OH 1,000

Production supervisors’ salary P - OH 3,000

Manager’s remuneration NP – A 2,600

Depreciation of building:

Depr.of building (office = 30% x 1,500) NP – A 450

Depr.of building (factory = 70% x 1,500) P – OH 1,050

Specialized machine rental cost P – DE 1,200

Depreciation of office equipment NP – A 300

Sales commission NP – S&D 1,700

Utilities (20% for office area):

Utilities (office = 20% x 2,700) NP – A 540

Utilities (factory = 80% x 2,700) P – OH 2,160

Product promotion cost NP – S&D 600

Depreciation of delivery van NP – S&D 400

Other Administrative costs NP - A 1,800

Total Cost 30,850

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Step 2: Prepare the cost statement

Maya Frozen Enterprise
Cost Statement for the month of October 20X1

RM RM
6,650
Direct Materials: 7,000
1,200
Raw materials 6,000 14,850
Delivery cost for raw materials 650
7,210
Direct Labor: 22,060
Production operators’ wages
6,090
Direct Expense: 1,000
Specialized machine rental cost 3,000 2,700
1,050 30,850
PRIME COST 2,160
Add: Production Overheads
Wages of cleaners
Production supervisors’ salary
Depreciation of building (70% x 1,500)
Utilities (80% x 2,700)

TOTAL PRODUCTION COST 400
Add: Non-Production Overheads 2,600
Administrative: 450
Wages of cleaners 300
Manager’s remuneration 540
Depreciation of building (30% x 1,500) 1,800
Depreciation of office equipment
Utilities (20% x 2,700) 1,700
Other Administrative costs 600
Selling & Distribution: 400
Sales commission
Product promotion cost
Depreciation of delivery van

TOTAL COSTS

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