Introduction to Cost

Accounting
Presented by:
1. Varun Achar (20181001)
2. Janit Gupta (20181015)
3. Fenil Maru (20181029)
4. Pranav Sarawagi (20181042)
5. Nitin Verma (20181055)
6. Rishabh Kumbhat (20181124)
I. INTRODUCTION TO COST ACCOUNTING

Cost is the amount of resource given up in exchange for some goods or services. The resources
given up are money or money’s equivalent expressed in monetary units. The Chartered Institute of
Management Accountants, London defines cost as “the amount of expenditure (actual or notional)
incurred on, or attributable to a specified thing or activity”. This activity of a firm may be the
manufacture of a product or the rendering of a service which involves expenditure under various
heads, e.g., materials, labour, other expenses, etc. A manufacturing organisation is interested in
ascertaining the cost per unit of the product manufactured while an organisation rendering service,
e.g., transport undertaking, canteen, electricity company, municipality, etc., is interested in
ascertaining the costs of the service it renders. In its simplest form, the cost per unit is arrived at by
dividing the total expenditure incurred by the total units produced or the quantum of service
rendered. But this method is applicable if the manufacturer produces only one product. If the
manufacturer produces more than one product, it becomes imperative to split up the total
expenditure between the various products so that the cost of each product can be ascertained
separately. Even if only one product is manufactured, it may be necessary to analyse the cost per
unit of each item of expenditure that goes to make up the total cost. The problem becomes more
complicated where a multiplicity of products is produced and it is necessary to analyse the cost per
unit of each product into various items of expenditures that make up the total cost. For a consumer
cost means price. For management cost means 'expenditure incurred' for producing a particular
product or rendering a particular service. The process of ascertaining the cost is known as costing. It
consists of principles and rules governing the procedure of finding out the costs of goods/ services. It
aims at ascertaining the total cost and also per unit cost. For instance, in transport companies the
total cost for the period is ascertained and used to find out the cost per passenger/mile. i.e. the cost
of carrying one passenger for one mile. It provides for analysis of expenditure in such a way that the
management gets complete idea about even the smallest item of cost.

Costing is the techniques and processes of ascertaining costs. These techniques consist of principles
and rules which govern the procedure of ascertaining cost of products or services. The techniques to
be followed for the analysis of expenses and the processes of different products or services differ
from industry to industry. The main object of costing is the analysis of financial records, so as to
subdivide expenditure and to allocate it carefully to selected cost centers, and hence to build up a
total cost for the departments, processes or jobs or contracts of the undertaking.

Cost accounting may be regarded as ``a specialised branch of accounting which involves
classification, accumulation, assignment and control of costs. The Costing terminology of C.I.M.A.
London defines cost accounting as ``The establishment of budgets, standard costs and actual costs of
operations, processes, activities or products, and the analysis of variances, profitability or the social
use of funds”. `Wheldon defines cost accounting as “classifying, recording and appropriate allocation
of expenditure for 4 EP-CMA determination of costs of products or services and for the presentation
of suitably arranged data for purposes of control and guidance of management”. It is thus, a formal
mechanism by means of which costs of products or services are ascertained and controlled. Cost
accounting is different from costing in the sense that the former provides only the basis and
information for ascertainment of costs. Once the information is made available, costing can be
carried out arithmetically by means of memorandum statements or by method of integral
accounting.
 Cost Accountancy has been defined as “the application of costing and cost accounting principles,
methods and techniques to the science, art and practice of cost control and the ascertainment of
profitability. It includes the presentation of information derived there from for the purpose of
managerial decision making”.

II. IMPORTANCE OF COST ACCOUNTING :

1. Cost accounting helps in periods of trade depression and trade competition - In periods of trade
depression, the organisation cannot afford to have losses which pass unchecked. The management
must know the areas where economies may be sought, waste eliminated and efficiency increased.
The organisation has to wage a war not only for its survival but also continued growth. The
management should know the actual cost of their products before embarking on any scheme of
price reduction. Adequate system of costing facilitates this.

2. Cost accounting aids price fixation - Although the law of supply and demand to a great extent
determines the price of the article, cost to the producer does play an important role. The producer
can take necessary guidance from his costing records in case he is in a position to fix or change the
price charged.

3. Cost accounting helps in making estimates - Adequate costing records provide a reliable basis for
making estimates and quoting tenders.

4. Cost accounting helps in channelising production on right lines - Proper costing information
makes it possible for the management to distinguish between profitable and non-profitable
activities. Profits can be maximised by concentrating on profitable operations and eliminating non-
profitable ones.

5. Cost accounting eliminates wastages - As cost accounting is concerned with detailed break-up of
costs, it is possible to check various forms of wastages or losses.

6. Cost accounting makes comparisons possible - Proper maintenance of costing records provides
various costing data for comparisons which in turn helps the management in formulation of future
lines of action.

7. Cost accounting provides data for periodical profit and loss account - Adequate costing records
provide the management with such data as may be necessary for preparation of profit and loss
account and balance sheet at such intervals as may be desired by the management.

8. Cost accounting helps in determining and enhancing efficiency - Losses due to wastage of
materials, idle time of workers, poor supervision, etc., will be disclosed if the various operations
involved in the production are studied carefully. Efficiency can be measured, costs controlled and
various steps can be taken to increase the efficiency.

9. Cost accounting helps in inventory control - Cost accounting furnishes control which
management requires in respect of stock of materials, work-in-progress and finished goods.

III. BENEFITS OF COST ACCOUNTING

1. Measurement and Improvement of Efficiency:

The chief advantage to be gained is that Cost Accounting will enable a concern to, first of all,
measure its efficiency and then to maintain and improve it. This is done by suitable comparisons and
analysis of the differences that may be observed. For example, if materials spent upon a pair of
shoes in 2001 come to Rs. 100 and for a similar pair of shoe the amount is Rs. 120 in 2002. It is an
indication of decline in efficiency.

Of course, the increase may only be due to increase in price of materials; it may also be due to
greater wastage in use of materials or inefficiency at the time of buying so that unnecessary high
prices were paid. Comparisons may also be made with average figures for the whole industry (if such
figures are available) and with ideal figures which may have been determined before head.

2. Profitable and Unprofitable Activities:

It will throw light upon those activities which bring profits and those activities which result in losses.
This will be done only if the cost of each product or each job is ascertained and compared with the
price obtained.

3. Fixation of Prices:

In many cases a firm is able to fix a price for its products on the basis of the cost of production. In
such a case, price cannot be properly fixed if no proper figures of cost are available. In case of big
contracts, no quotation can be made unless the cost of completing that contract can be ascertained.

If prices are fixed without costing information, it is possible that the price quoted may either be too
high, in which case orders cannot be obtained, or it may be too low, in which case an order will
result in a loss. It is a mistake on the part of any management to believe that mere increase in sales
volume will result in profits; increased sales at prices lower than the cost may well lead the concern
to the bankrupt court. Only Cost Accounting will reveal what price will be profitable.

4. Guide in Reducing Prices:

In certain periods it becomes necessary to reduce the price even below the total cost. This will be so
when there is a depression or slump. Costs, properly ascertained, will guide management in this
direction.

5. Information for Proper Planning:

For a proper system of Costing, it is necessary to have detailed information about the facilities
available about machine and labour capacity. This helps in proper planning of work so that no
section is overworked and no section remains idle.

6. Decision Regarding Machine vs. Labour:

Some of the important questions before management can be solved only with the help of
information about costs. For example, if there is the problem of replacement of labour by
machinery, Cost Accounting will at least guide management in finding out what the cost of
production will be if either machinery or labour is used.

7. Expansion in Production:
 Sometimes it is necessary to decide whether production of one product or the other is to be
increased. This problem can also be solved only if proper information about costs is available.

8. Reasons for Losses Detected:

Exact causes of existence of profits or losses will be revealed by a system of Cost Accounting. For
example, a concern may suffer not because the cost of production is high or prices are low but
because the output is much below the capacity of the concern. It is only Cost Accounting which will
reveal this reason for loss. It also helps in distinguishing between expenditure and loss which is
necessary and that which is unnecessary, that is to say, between normal and abnormal losses.

9. Helps in Taking Decisions:

Cost Accounting inculcates the habit of making calculations with pencil and paper before taking a
decision. It will certainly check recklessness. Also some of the silly mistakes that sometimes occur
can be avoided if there is a good Cost Accounting system. To give an instance, a well-known firm
once quoted for supply of mosquito nets to the Government at a very low price. It was only after the
order was obtained that the firm found that, by mistake, the price of materials was not included in
the quotation.

10. Check on Accuracy of Financial Accounts:

A good system of Cost Accounting affords an independent and most reliable check on the accuracy
of financial accounts. This check operates through reconciliation of profits shown by Cost Accounts
and by Financial Accounts. On the basis of various advantages of Cost Accounting, it can be easily
said that ‘a good system of costing serves as a means of control over expenditure and helps to
secure economy in manufacture’.

IV. Difference Between Management Accounting and Financial Accounting

Meaning

Management accounting is a process of preparing management reports and accounts that provide
accurate and timely financial and statistical information required by the managers to make day-to-
day and short term decisions. Unlike Financial accounting, which produces annual reports mainly for
external stakeholders.

Information

Management accounting provides monetary as well as non-monetary information. Financial

accounting provides information related to monetary things.

Objective

Management accounting focuses on assisting the management in planning and decision making
process by providing detailed information on various matter like, amount of available cash, sales
revenue generated, amount of order in hand, etcFinancial accounting provides financial information
to interested parties like shareholders, suppliers and other stakeholders.
 Format

There is no specific format used in management accounting, whereas in financial accounting there
are specific format that has to be followed.

Time Frame

The reports in management accounting are prepared as per the need and requirements of the
organization. In financial accounting statements are prepared at end of the accounting period which
is usually one year.

Users

Management accounting is used only by internal management, whereas financial accounting is used
by internal as well as external parties.

Reports

Management accounting provides very detailed and complete reports regarding various information
that help the management to take decisions. Financial accounting provides summarized reports
about the financial position of the organization.

Publishing and auditing

Management accounting does not require any kind of auditing or publishing, whereas financial
accounts are required to be audited and published by statutory auditors.

V. STRATEGIC COST MANAGEMENT

Strategy specifies how an organization matches its own capabilities with the opportunities in the
marketplace to accomplish its objectives. In other words, strategy describes how an organization will
compete and the opportunities its managers should seek and pursue. Businesses follow one of two
broad strategies. Some companies, such as Southwest Airlines and Vanguard (the mutual fund
company) follow a cost leadership strategy. They have been profitable and have grown over the
years on the basis of providing quality products or services at low prices by judiciously managing
their costs. Other companies such as Apple Inc., the maker of iPods and iPhones, and Johnson &
Johnson, the pharmaceutical giant, follow a product differentiation strategy. They generate their
profits and growth on the basis of their ability to offer differentiated or unique products or services
that appeal to their customers and are often priced higher than the less-popular products or services
of their competitors.

Deciding between these strategies is a critical part of what managers do. Management accountants
work closely with managers in formulating strategy by providing information about the sources of
competitive advantage—for example, the cost, productivity, or efficiency advantage of their
company relative to competitors or the premium prices a company can charge relative to the costs
of adding features that make its products or services distinctive. Strategic cost management
describes cost management that specifically focuses on strategic issues.
 Management accounting information helps managers formulate strategy by answering questions
such as the following:

Who are our most important customers, and how can we be competitive and deliver value to them?

After Amazon.com’s success in selling books online, management accountants at Barnes and Noble
presented senior executives with the costs and benefits of several alternative approaches for
building its information technology infrastructure and developing the capabilities to also sell books
online. A similar cost-benefit analysis led Toyota to build flexible computer-integrated
manufacturing (CIM) plants that enable it to use the same equipment efficiently to produce a variety
of cars in response to changing customer tastes.

What substitute products exist in the marketplace, and how do they differ from our product in terms
of price and quality?

Hewlett-Packard, for example, designs and prices new printers after comparing the functionality and
quality of its printers to other printers available in the marketplace.

What is our most critical capability? Is it technology, production, or marketing? How can we leverage
it for new strategic initiatives? Kellogg Company, for example, uses the reputation of its brand to
introduce new types of cereal.

Will adequate cash be available to fund the strategy, or will additional funds need to be raised?

Proctor & Gamble, for example, issued new debt and equity to fund its strategic acquisition of
Gillette, a maker of shaving products. The best-designed strategies and the best-developed
capabilities are useless unless they are effectively executed. In the next section, we describe how
management accountants help managers take actions that create value for their customers.

VI. Components of SCM

1. Cost driver analysis

A cost driver is an activity that is the root cause of why a cost occurs. It must be applicable and
relevant to the event that is incurring a cost. There may be multiple cost drivers responsible for the
occurrence of a single expense.A cost driver assists with allocation expenses in a systematic manner
that theoretically results in more accurate calculations of the true costs of producing specific
products.

The most common cost driver has historically been direct labor hours. Expenses incurred relating to
the layout or structure of a building or warehouse may utilize a cost driver of square footage to
allocate expenses.
More technical cost drivers include machine hours, the number of change orders, the number of
customer contacts, the number of product returns, the machine setups required for production, or
the number of inspections.

A factory has a machine that requires periodic maintenance. This maintenance incurs costs to be
allocated to the products produced by the machinery. Therefore, the cost driver is identified and
used as a base to distribute the costs. In this example, the cost driver selected is "machinery hours."
It is determined that after every 1,000 machine hours, maintenance costing $500 is performed.
Therefore, every machine hour results in an eventual 50 cents in maintenance costs that can be
allocated to the product being manufactured based on the cost driver of machine hours.

2. Strategic positioning analysis

Strategic positioning analysis is an approach for researching what future environments might be like
in your internal corporate structure as well as your external environment and determining how you
can use the choice of business strategies to get from your current situation to these desirable goals.
The ultimate goal of this work is to ensure the continuity of the company.

Analysis starts with establishing what trends you can perceive. This means working out what
technological/business opportunities or customer segments are altering which could turn into
tomorrow’s big earners. This becomes important to strategic cost management since investment in
new technologies or risky new ventures can be highly risky.

Analysis of the status-quo often involves using some fairly standard strategic management tools
such as:

 SWOT analysis – Strengths and weaknesses within your firm; opportunities and threats
within the external competitive market.

 Product/market matrix – Establishing what new markets, product changes, product lines or
market variations could prove profitable.

 Portfolio analysis – Establishing which of your projects are potential cash cows, stars,
wildcats or dogs.

3. Value chain analysis

Value chain analysis is an approach used to determine the series of activities involved in creating and
building value within your operations. It requires a systematic approach to examining each different
element in your primary activities as well as support activities.

The operations of the organization may actually be split out into both primary as well as support
activities.

 Primary activities: Inbound logistics, operations, outbound logistics, marketing & sales and
service.

 Support activities: Procurement, technology development, human resources management

and firm infrastructure.
These have a bearing on strategic cost management since all of these activities have a bearing on
operational, structural and executional costs. By making strategic decisions around your value chain
you can actually determine the level of these costs.