3rd Semester
Principles of Cost and Management Accounting
Summer 2020
Chapter 1
Introduction
Cost
Cost is defined as the amount of resources that must be sacrificed to acquire a product or service.
If we buy a watch for $30, the amount of dollars is considered to be the cost of that watch. Here,
30 dollars are sacrificed to obtain a watch.
Expense
An expense is a cost that has expired or was necessary in order to earn revenues. An expense is
a cost that has expired or consumed.
Examples of Cost and Expense:
A company has a cost of $6,000 for property insurance covering the next six months. Initially
the cost of $6,000 is reported as the current asset Prepaid Insurance. However, in each of the
following six months, the company will report Insurance Expense of $1,000—the amount that is
expiring each month. The unexpired portion of the cost will continue to be reported as the
asset Prepaid Insurance.
The cost of equipment used in manufacturing is initially reported as the long-lived asset
Equipment. However, in each accounting period the company will report part of the asset's cost
as Depreciation Expense.
Costing
The Institute of Cost and Management Accountants (ICMA), London has defined costing as the
technique and process of ascertaining costs.
Cost Accounting
Cost accounting, as a tool of management, provides management with detailed records of the
costs relating to products, operations or functions. Cost accounting refers to the process of
determining and accumulating the cost of some particular product or activity. It also covers
classification, analysis and interpretation of costs. The costs so determined and accumulated may
be the estimated future costs for planning purposes, or actual (historical) costs for evaluating
performance.
The Institute of Cost and Management Accountants, London, defines cost accounting as "the
process of accounting for cost from the point at which expenditure is incurred or committed to
the establishment of its ultimate relationship with cost centres and cost units. In its widest usage
it embraces the preparation of statistical data, the application of cost control methods and the
ascertainment of the profitability of activities carried out or planned".
3rd Semester
Principles of Cost and Management Accounting
Summer 2020
Cost Centre
Cost Centre is a location, person or an asset for which costs can be ascertained and used for the
purpose of cost control. For example, in production department, a machine or group of machines
within a department is considered as Cost Centre.
Cost Unit
A cost unit is a unit of quantity of product or service in relation to which cost may be ascertained.
Objectives of Cost Accounting:
1. Cost Ascertainment: To determine the cost of a product is the basic objective of cost
accounting.
2. Cost Control: This objective is achieved by setting standard of performance. Actual costs
are compared with predetermine standards. Deviation if any is immediately corrected.
The controlling function is performed by managers at different level.
3. Decision Making: Choosing amongst alternatives is also one of the objectives of cost
accounting.
4. Fixation of Selling Price: Fixing of selling price is another objective of cost accounting.
Unless the cost is known, the required percentage of profit cannot be added to cost to
determine selling price.
Advantages of Cost Accounting
I. The cost accounting system provides data, about profitable and unprofitable products
and activities. After investigating the causes of low profitability and unprofitability,
management can take suitable corrective measures which may lead to higher profit.
II. All items of costs can be analyzed to minimize the wastage emerging from the
manufacturing process.
III. Cost accounting also provides cost data and information to determine the price of the
product.
IV. An adequate cost accounting system ensures maximum utilization of physical and human
resources.
Limitations of Cost Accounting
Based on Estimates: In cost accounting, costs are charged to products and process on the basis
of estimates. Actual cost varies from estimated cost. Due to this limitation, all cost accounting
results are taken as mere estimates.
Lack of Uniformity: Procedures of cost accounting followed by different organization are
different for different products. There is no uniformity. It leads to different cost results for the
same operation
3rd Semester
Principles of Cost and Management Accounting
Summer 2020
Does not include all items of expense and income: Items of purely financial nature such as
interest, financial charges, discount and loss on issue of shares and debentures, etc. are not taken
into consideration in cost accounting.
Methods of Costing:
Job costing: - Job costing is used in those business concerns where production is carried out as
per specific order and customers specifications. Each job or product is separate and distinct from
other jobs or products. The method is popular in enterprise engaged in house building, ship
building, machinery production and repair. Job costing has the following variants:
1. Batch Costing: This method is used to determine the cost of a group or identical or similar
products. The batch consisting of similar product is the unit and not the single item within
the batch. For example, a bicycle factory may produce 10,000 handles at one time then
take up the manufactures of other parts.
2. Contract Costing: - This method is used by contractors for construction of building bridges
etc. Here the unit of cost is a contract.
3. Multiple Costing: - This is used in industries where the nature of the product is complex
such as automobile, aero plane industries etc., Here the cost of components is calculated
separately. Each component has a job sheet. These are assembled to complete the cost
of aero plane or other finished product.
Process Costing: -This method is used by industries manufacturing products by continuous
processes.
a. Operation Costing: -Operation Costing is applied where the production passes through
several operations successively before the final product is made. Operation costing is
used in industries such as shoe making, furniture making industries
b. Single or Output or Unit Costing: - This method is applied where the production is of
continuous nature and the final product is only one or the different grades of same
product. Examples of the industries applying this method are mining industry.
c. Operating costing: Organizations which undertake service rather than manufacture
ascertain operating costs.
Distinction between cost and financial accounting:
❖ The major objective of financial accounting is external reporting where the major
objective of cost accounting is internal reporting i.e. management.
❖ Financial accounting is mostly historical or after the event. But cost accounting includes
both retrospective and anticipatory calculations.
3rd Semester
Principles of Cost and Management Accounting
Summer 2020
❖ Financial accounting uses generally accepted Accounting Principles while recording
whereas cost accounting is not bound to use GAAP and it can use any technique or
practice which generates useful information.
❖ Financial accounting data are developed for a definite period, usually a year whereas cost
accounting reports and statements can be prepared whenever needed.
