CHAPTER 1

Introduction to Cost Accounting

 Learning Objectives
◦ Upon completion of this chapter, you should be able to:

◦ Distinguish between financial, managerial, and cost accounting

◦ Distinguish between merchandising and manufacturing operations
◦ Identify the uses of cost accounting data
◦ Distinguish between job order costing and process costing
◦ The main and primary objective of accounting is to provide financial information about an economic
entity to different types of users. First we have external users - managers for planning, controlling and
decision making. Then we have external users – the government, those who provide funds and those who
have various interests in the operations of the of the entity.
◦ Cost Accounting is an expanded phase of general or financial accounting which informs management
promptly with the cost of rendering a particular service, buying and selling a product, and producing a
product. It is the field of accounting that measures, records, and reports information about costs.
◦ All types of business entities – manufacturing, merchandising, and service businesses – require
information systems which provide the necessary financial data. Because of the nature of the
manufacturing process, the information systems of manufacturing entities must be designed to
accumulate detailed cost data relating to the production process. Thus, it is common today for small,
medium, and large manufacturing companies to have structured costs accounting systems. These systems
should show what cost were incurred and where and how these costs were utilized. Cost accounting
today is recognized as being essential to efficient cooperation of business and industry.
◦ In order to appreciate the importance of an efficient cost system, it is necessary to understand the nature
of the manufacturing process. In many ways, the activities of a manufacturing organization are similar to
those of a merchandising business. Both are concerned with purchasing, storing, and selling goods: both
must have efficient management and adequate sources of capital: both may employ hundreds or
thousands of workers. In the manufacturing process itself, we see the distinction between the two:
merchandisers, such as SM buy items in marketable form to be resold to their customers, manufacturers,
such as PHILACOR, must make the goods they sell. Once the merchandising organization has acquired
and stored goods, it is ready to carry out the marketing function. The purchase of materials by a
manufacturer, however, is only the beginning of a long, and sometimes complex, chain of events that will
eventually produce a finished article ready for sale.
◦ The manufacturing process involves the conversion of raw materials into finished goods through the
application of labor and the incurrence of various factory expenses. The manufacturer must make a major
investment in physical facilities, such as factory buildings and warehouses, and acquire many specialized
types of machinery and equipment. In order to carry out the manufacturing process, the manufacturer
must purchase appropriate qualities of raw materials, supplies and parts, an build up a work force to
covert these resources into finished goods.
◦ Once the goods are completed and are ready for sale, the manufacturer performs basically same functions
as the merchandiser in storing and marketing the goods. The methods of accounting for sales, cost of
goods sold, and selling and administrative expenses are also similar to those of the merchandising
organization.
◦ Although cost accounting developed originally in manufacturing business to satisfy management’s need
for product cost information, cost accounting information is useful for all types of activities in all types
of organizations. Cost accounting is essential not only for profit- seeking entities but also for not –for-
profit organizations such as governmental agencies, churches, and charities.
 Comparison of

FINANCIAL MANAGERIAL COST

ACCOUNTING ACCOUNTING ACCOUNTING
 FINANCIAL ACCOUNTING Suppliers of
◦ Financial Accounting is the use of accounting information for Funds
reporting to external parties, including investors an creditors. • Stockholders
◦ Financial Accounting is primarily concerned with financial • Partners
statements for external use by those supply funds to the entity and • Sole Proprietors.
other persons who may have vested interest in the financial
operations of the firm. Creditors
◦ Financial Accounting is based on historical transaction data • who provide debts are also
◦ The information maybe historical, quantitative, monetary and verifiable. interested on the financial
◦ The data are historical and are supported by documents. statement of the entity.
◦ The information provided by financial accounting is usually presented in
the form of financial statement, tax returns, and other formal reports
distributed to various external users.
Financial Statement
• are the output from the
accounting system.
MANAGERIAL ACCOUNTING
◦ Managerial Accounting focuses on the needs of parties within the organizations, rather than interested parties outside the
organization.
◦ Managerial Accounting information commonly addresses individual or divisional concerns rather than those of the enterprises as
a whole.
◦ The information may be current or forecasted, quantitative or qualitative, monetary or non-monetary and most of all timely the data futuristic and
some of the costs are not recorded on the accounting books of the organization.

◦ Managerial Accounting is not separate and distinct from financial accounting. Financial Accounting data are used in the
managerial accounting system. Management decisions made today will affect the financial statement of future periods. There is
no requirement or legislation that mandates the format or use of managerial accounting. Managerial accounting methods are tools
that are available for use to management.
◦ Financial accounting attempts to present some degree of precision in reporting historical information while at the same time
emphasizing verifiability and freedom from bias in the information, relevance to general verifiability and freedom from bias in
the information, relevance to the general user and some degree of timeliness in reporting which is not as critical in managerial
accounting.
◦ The timing of information and its relevance to the decision on hand has greater significance to the international decision-maker.
Management is more concerned on the timeliness of the information so management cannot wait until tomorrow of information
that required for today’s decision.
 Economic measure such as pesos

Various bases
may be Physical measure such as pound, gallons,
appropriate to tons, or units

report
Relationship measure such as ratios
managerial
information
COST ACCOUNTING
◦ Cost Accounting is the intersection between financial and managerial accounting. Cost accounting information is
needed and used by both financial and managerial accounting. Cost accounting provides product cost information to
external parties, such as stockholders, creditors and various regulatory boards for credit and investment decisions.
Cost accounting provides product information also to internal parties such as managers for planning and controlling.

Financial Cost Management

Accounting Accounting Accounting
 Figure 1-1 . Cost of Goods sold for a Merchandising Company

Balance Sheet Transaction Income Statement

Preparation Preparation
Cash

Purchases

Plus:
Merchandise
Inventory
beginning

Cost of
MI Cost of Cost of Goods Cost of
Goods
End Unsold Items Available for sale old items
Sold
 Figure 1-2 Cost of Goods Sold for a Manufacturing Company

Balance Sheet Transaction Income Statement

Preparation Preparation
Cash

Purchase of

Materials Labor Factory OH

Unused Materials
Mat. Invty
Storage
When Used

WP Invty Unfinished
Production Process

Unsold Products Products Sold Cost of

Finished Goods
FG Invty
Storage
Goods
Sold
 USES OF COST ACCOUNTING DATA
The information product by a cost accounting system provides a basis for determining product
cost and aids management in planning and controlling operation
Determining Product Costs
Cost accounting procedures helps management in gathering the data needed to determine product costs
and thus generate meaningful financial statements and other reports. Cost procedures must be designed
to permit the computation of unit costs as well as total product cost.

Unit cost information is also useful in making a variety of important marketing decision.

◦ Determining the selling price of product.

◦ Meeting Competition
◦ Bidding on Contracts
◦ Analyzing profitability
1. Determining the selling price of product. A knowledge of the cost of manufacturing a unit of product
helps in setting the selling price, which should be high enough to cover the cost of production, pay a
portion of marketing and administrative expenses and provide a profit. It will be difficult to set the
selling price without knowing the costs incurred in the manufacturing of a product and cost incurred in
rendering a service.
2. Meeting competition. If a competitor is selling the product at a low price, detailed information
regarding unit costs can be used to determine the action to be taken by the company. The company
would know if selling price must be reduced, or manufacturing costs must be reduced, or the product
must be eliminated.
3. Bidding on contracts. Many manufacturing firms must submit competitive bids in order to be awarded
manufacturing contracts by the government or private firms An analysis of the unit costs relating to the
manufacture of a particular product is of great importance in determining the bid price to be submitted.
The bid price must be able to cover cost to be incurred and at the same provide profit for the company.
It must not be set so high so as to be able to compete with other bidders.
4. Analyzing profitability. Unit cost information enables management to determine the amount of profit
that each product earns and possibly eliminate those that are least profitable, thereby concentrating
efforts on those items that are most profitable.

Cost are said to be used for managerial accounting purposes when cost are used inside the organization by
managers to evaluate the performance of operations or personnel, or as a basis for decision making. When
cost are used by outsiders, such as stockholders or creditors to evaluate the performance of top
management and make decisions about the organization, we say costs are used for financial accounting
purposes.
Planning and Control
One of the most important functions of cost accounting is the development of information which can be used by management in
planning and controlling operation. Planning is the process of establishing objective or goals for the firms and determining the
means by which the firm will attain them. Planning is essential to good management because it provides a means of coordination
all of the operations of firm. Cost accounting helps in the development of plans by providing historical costs that serve as basis
for projecting data for planning . Management can analyze trend and relationships among such data as an aid in estimating
future costs and operating results and in making decisions regarding the acquisition of additional facilities, change in marketing
strategies, and obtaining additional capital

Planning can be divided into three components:

1. Strategic planning
2. Tactical planning
3. Operations planning

Control is the process of monitoring the company’s operations and determining whether the objectives identified in the planning
process are being accomplished.
RECENT DEVELOPMENTS IN COST
ACCOUNTING
◦ Cost accounting is experiencing dramatic changes. Manual bookkeeping has been reduced because of the
use of computers. Changes in production methods have made traditional applications of cost accounting
obsolete in some cases. Increasing emphasis on cost control is seen now in hospitals, in industries facing
stiff foreign competition and in many organizations that have traditionally not focused on cost control.
◦ The traditional role of cost accounting is to record full product cost data for external reporting. However,
the use of accounting data for decision making and performance evaluation has gained importance in
recent years.
COST ACCOUNTING AND OTHER FIELDS
OF STUDY
◦ The recording of the costs of a product or a service is part of financial accounting. The use of cost for
valuation of inventory and cost of good sold for external reporting is also financial accounting. The use
of cost data in choosing between two or more alternatives is part of managerial accounting. Differential
cost analysis is considered by others as a form of applied microeconomics. Cost accounting provides data
for use in decision models for finance, operations management, and marketing. Cost accounting is also
related to motivation and behavior because it is used in planning and performance evaluation. Finally ,
tools from statistics, mathematics, and computer science are used to perform cost analysis.
TWO BASIC PRODUCT-COSTING SYSTEM
◦ JOB ORDER COSTING ◦ PROCESS COSTING
A system for allocating cost groups of unique a system applicable to a continuous process of
product. It is applicable to the production of production of the same or similar goods, e.g., oil
customer specified products such as the refining and chemical production. Since there is
manufacture of special machines. Each job no need to determine the costs of different
becomes a cost center for which cost are groups of products because the product is
accumulated. A subsidiary record (job cost uniform, each processing department become a
sheet) is needed to keep track of all unfinished cost center.
jobs (work in process) and finished jobs
(finished goods).
Job Order versus Process Costing
◦ Job order costing and process costing are two traditional basis approaches to product cost accounting
systems. Actual cost accounting systems may differ widely. However, all are based on one of these two
product costing concepts. Once the type of system is selected, it is then adjusted to fit a particular
industry, company, or operating department. The objective of the two systems is the same. They both
provide product unit cost information for pricing, cost control, inventory valuation, and income statement
preparation. End-of-period values for the Cost of Good Sold, Work in Process Inventory, and Finished
Goods Inventory accounts are computed using product unit cost data.
Characteristics of Job Order Costing
Job order cost accounting system

is a product costing system used by companies making one-of-a-kind or special order products. In such a
system, direct materials, direct labor, and factory overhead cost are assigned to specific job order or
batches of production. In computing unit costs, the total manufacturing cost for each job order are
divided by the number of good units produced for that order. Industries that use a job order cost
accounting system include those that make ships, airplanes large machines, and special orders. Job order
costing may also be used when producing a set quantity of a product for inventory replenishment, such
as a production run of 500 identical lawn mowers. Procedures similar to those used in job-order costing
are used I many service industry firms, even if these firms have no work in process or finished goods
inventories. In a public accounting firms, for example, cost are assigned to audit engagements. For
consulting and architectural firms, cost are assigned to contracts, while for universities it maybe for
every research project.
The primary characteristics of a job order cost system are as follows:

1. It collects all manufacturing costs and assigns them to specific job or batches of product.
2. It measures costs for each completed job, rather than for set time periods.
3. It uses just one Work in Process Inventory Control account in the general ledger. The account is
supported by a subsidiary ledger of job order cost cards or sheets for each job in process at any point of
time.
Characteristics of Process Costing
A process cost accounting system is a product costing system used by companies that make a large
number of similar products or maintain a continuous production flow. In these cases, it is more
economical to account for products-related cost for a period of time (a week or a month) than to try to
assign them to specific products or job orders. Unit costs are computed by dividing total manufacturing
cost assigned to a particular department or work center during a period by the equivalent unit of
production. If a product is routed through four departments, then four unit cost amounts are added to
find the product’s total unit cost. Companies producing paint, oil and gas, automobiles, bricks, or soft
drinks uses some of a process costing system.
The main characteristics of a process cost accounting system are as follows:

1. Manufacturing costs are grouped by department or work center, with little concern for specific job
orders.
2. It emphasizes a weekly or monthly time period rather than the time taken to complete a specific order.
3. It uses several Work in Process Inventory account – one for each department or work center in the
manufacturing process.
 Many manufacturing firms have production system which are not suited for strictly job-order costing or
process costing, but instead require a costing system which incorporation ideas from both. This blending of
ideas is known as hybrid costing. The continuum below demonstrates the relationship between these
costing systems.

Job-order Process
Hybrid
Product- costing Product-costing
Cost System
system system
◦ The costing system an organization selects will mainly depend on its underlying production system.
Operation costing is hybrid costing system often used in repetitive manufacturing where finished
products have common, as well as distinguishing characteristics. For example, in the manufacture of
clothing, basic suits can be assembled in one operation. These suits can then move on the next operation
and have a deluxe lining added. Based on the variations. The products and assembly plant, which
produces a basic chassis and component system, but which varies options such as remote contorl and
cabinetry would be a logical user of operation costing.
◦ Some companies process large order of identical units as a group through the same production sequence.
Each of these orders is called a batch. In batch production cost are allocated to each batch. Whenever a
change in production line is required to continue production, a new batch is created. A furniture
manufacturer may produce a batch of chairs, then a batch of tables, then a batch of drawers, and so forth.
Generally, job costing concepts are used to account for batch production and each batch is treated as a
job for costing purposes.
MAJOR DIFFERENCES BETWEEN PROCESS & JOB ORDER COSTING

PROCESS COSTING JOB ORDER COSTING

1. Homogeneous units pass through a series of 1. Unique jobs are worked on during a time
similar processes. period

2. Cost are accumulated by processing department 2. Cost are accumulated by individual job

3. Unit cost are computed by dividing the

3. Unit cost are determined by dividing the
individual departments’ cost by the equivalent
total costs on the job cost sheet by the
production
number of units on the job

4. The Cost of production report provides the

detail of the Work in Process account for each 4. The job cost sheet provides the details for
department the work in process account
◦ In job costing, cost are accumulated for each for each job or batch produced. In process costing, cost are
accumulated by department for an accounting period. Process costing has less detailed recordkeeping,
hence, if a company was choosing between job and process costing,, it would generally find that
recordkeeping cost are lower under process costing. Process costing does not provide as much
information as job costing because records of the cost of each unit produced are not kept using process
costing. The choice of process versus job costing systems involves a comparison of the costs and benefits
of each system.
◦ As a general rule job systems are usually more costly than process systems. So if managers and
accountants must decide whether to use job costing or process costing, recordkeeping costs must be
compared with additional benefits that will be derived from knowing the actual cost of each unit. If
recordkeeping costs were equal under job and process systems, for the units in a product line, then the
job costing systems are better because they provide all of the data that process system do.