AC 207 COURSE OUTLINE

COURSE PURPOSE
• For the student to gain the necessary knowledge, skills, attitudes and
competencies to analyse and solve problems relating to the general principles
of cost accounting, with specific reference to manufacturing and service
environments.
COURSE OBJECTIVES
• This course is designed to provide the student with facts; theories and
concepts in Cost Accounting. This is the first course; in a two part course
series (the other being Cost Accounting and Control 11 covered during second
semester). A sound grounding in cost concepts and management accounting
application is essential for a proper understanding in the subsequent years.
 Course Outline continues….
1. Introduction
2. Overheads
3. Labour
4. Material
5. Specific order costing
a) Job costing
b) Batch costing
c) Contract costing
d) Service costing
6. Process Costing
 Course Outline continues….
Reading Material
1. Cost Accounting: A Management Emphasis- 5th Edition by Horngren
C.T. Published by Prentice Hall.
2. Costing: T. A . Lucey – 4th Edition by DP Publishing.
3. Management and Cost Accounting: C Drury- 8th Edition by – 7th
Edition
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OBJECTIVES
After studying this chapter, readers should be able to:
• The objectives of Profit and non-Profit organizations
• The scope of management accounting in an enterprise
• the concept of cost; profit and investment centers
• Various ways of classification of costs
• Coding of costs in the accounting system
• Costing behavior and estimation
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1.1 The objectives of Profit and non-Profit organisations
• Profit organisations have the following objectives:

1. Profitability- Maintaining profitability means making sure that revenue stays ahead of the
costs of doing business
2. Productivity- Employee training, equipment maintenance and new equipment purchases
all go into company productivity. Your objective should be to provide all of the resources
your employees need to remain as productive as possible.
3. Customer Service- Good customer service helps you retain clients and generate repeat
revenue. Keeping your customers happy should be a primary objective of your organization.
4. Employee Retention- Employee turnover costs you money in lost productivity and the costs
associated with recruiting, which include employment advertising and paying placement
agencies.

Give examples of profit organisations you know

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• Non-profit organizations aim to improve society in some way, bettering the
communities they serve. In many cases, these non-profits are closely monitored
to ensure that they work to reach these objectives. Following are some
objectives for cost accounting in non--profit organisations:
1. To evaluate the performance of organizations in terms of achieving their
goals for which they were created.
2. To judge whether those organizations are appropriating the funds with
three E’s viz. economically, effectively and efficiently.
3. To examine the compliance of rules, regulations, bye-laws in the
organizations.
4. To submit management accounts to the stakeholders with whom they are
registered.
• Examples are Clubs, Churches, International Bodies like AU, Professional
accounting bodies e.g. ICAZ, ACCA e.t.c
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1.2 The scope of management accounting in an enterprise
• The process of preparing management reports and accounts that
provide accurate and timely financial and statistical information
required by managers to make day-to-day and short-term decisions.
• Users of accounting information can be divided into two categories:

a) External parties outside the organization (financial accounting).

b) Internal parties within the organization (management
accounting).
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Definition of Cost Accounting
Cost Accounting is the application of accounting and costing principles,
methods and techniques in the ascertainment of cost and the analysis
of savings and or excesses as compared with previous experience or
standard. ( CIMA Terminology).
The points to note about this definition are that: Cost accounting
involves:
• The application of costing principles, methods and techniques
• The ascertainment of cost
• Analysis of savings or overage
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Again cost accounting could be defined as:
“That part of management accounting which establishes budgets and
standard cost and actual cost of operations, processes, departments or
products and the analysis of variances, profitability or social use of
funds”. (CIMA Terminology)
The issues to remember about this definition are that, cost accounting is
• Part of management accounting
• Concerned with establishing budgets
• Standard costs and revenues
• Actual cost and revenues
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Major differences between financial and management accounting:

• Statutory requirement for public companies to produce annual financial accounts,
whereas there is no legal requirement for management accounting.
• Financial accounting reports describe the whole of the organization, whereas
management accounting focuses on reporting information for different parts of the
business.
• Financial accounting reports must be prepared in accordance with generally
accepted accounting principles (e.g. IASs/IFRSs).
• Financial accounting reports historical information, whereas management
accounting places greater emphasis on reporting estimated future costs and
revenues.
• Management accounting reports are produced at more frequent intervals.
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Link of Management Accounting and Financial accounting

Source: CIMA
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Management accounting also involves the following key skills:
Analysis – understanding the story behind the numbers and using it to
make business decisions
Strategy – using the insight from analysis to help formulate business
strategy to create wealth and shareholder value.
Risk – applying analytical skills to look at end-to-end business processes
to identify and manage risk.
Planning – using accounting techniques to plan and budget.
Communication – knowing what information management needs and
explaining the numbers to non-financial managers.
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1.3 The concept of cost; profit and investment centers
Cost object
• A cost object is any activity for which a separate measurement of cost
is required (e.g. cost of making a product or providing a service).
• A cost collection system normally accounts for costs in two broad
stages:
1. Accumulates costs by classifying them into certain categories
(e.g. labour, materials and overheads).
2. Assigns costs to cost objects.
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Direct and indirect costs
Direct costs can be specifically and exclusively identified with a given cost
object.
Indirect costs cannot be specifically and exclusively identified with a given
cost object.
Indirect costs (i.e. overheads)are assigned to cost objects on the basis of
cost allocations.
Cost allocations = process of assigning costs to cost objects that involve the
use of surrogate, rather than direct measures.
The distinction between direct and indirect costs depends on what is
identified as the cost object.
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Categories of Manufacturing Costs
Traditional cost systems accumulate product costs as follows:

Direct materials xxx

Direct labour xxx
Prime cost xxx
Manufacturing overhead xxx
Total manufacturing cost xxx
Non-manufacturing overheads xxx
Total cost xxx
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Period and product costs
• Product costs are those that are attached to the products and
included in the stock (inventory valuation).
• Period costs are not attached to the product and included in the
inventory valuation.
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Example
Product costs = $100,000
Period costs = $80,000
50% of the output for the period is sold and there are no opening inventories.
Production cost (product costs) 100,000
Less closing stock (50%) 50,000
Cost of goods sold (50%) 50,000
Period costs (100%) 80,000
Total costs recorded as an
expense for the period 130,000
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Treatment of product & period costs

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Cost units
A cost unit is a unit of a product or a service to which costs can be traced.
For example, for a manufacturer of laptop computers, a cost unit would be a
laptop. For a bus company, a cost unit could be a bus journey.
It is important to be able to identify cost units to be able to:
• Work out the cost of providing that product or service
• Work out the resources needed: material, labour and other expenses to make
or supply the unit.
• In a profit-seeking organisation, to decide on a selling price that will allow a
profit to be made
• In a not-for-profit organisation, to plans to be made as to where to spend
resources.
• Control the use of resources by comparing actual costs to budgeted costs.
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Cost centres
A cost centre is a place to which costs can be traced or segregated.
A cost centre could be:
• A subsidiary company
• A division
• A department
• A person
• A production line
• A project
• A machine
The head of a cost centre will be responsible for costs only: not revenue or profits
Examples of cost centres can include: the IT department, quality control
department, the accounting department, the manufacturing facility.
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Profit centres
A profit centre is a place where both costs and revenues are identified.
As above, a profit centre could be: A subsidiary company, A division, A
department, A person, A production line e.t.c
The difference is that here, in addition to being responsible for costs,
the head of a profit centre will also be responsible for revenues.
The revenues could be sales to outside organisations or they could be
internal sales to elsewhere in the organisation. For example, an IT
department could be turned from a cost centre into a profit centre if it
were to be allowed to charge IT users for the services supplied.
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Investment centres
An investment centre is a place where costs, revenues and capital
investment are identified.
Because costs, revenue and capital expenditure all have to be identified
separately an investment centre would normally be:
• A subsidiary company
• A division
The head of an investment centre will be responsible for costs revenues
and capital expenditure. In effect, that person has responsibility for all
financial aspects of the investment centre.
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1.4 Various ways of classification of costs
It is important to predict costs and revenues at different activity levels for many
decisions.
• Variable costs vary in direct proportion with activity.
• Fixed costs remain constant over wide ranges of activity.
• Semi-fixed costs are fixed within specified activity levels, but they eventually
increase or decrease by some constant amount at critical activity levels.
• Semi-variable costs include both a fixed and a variable component (e.g.
telephone charges).
• Note that the classification of costs depends on the time period involved. In
the short term some costs are fixed, but in the long term all costs are variable.
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Avoidable and unavoidable costs
• Avoidable costs are those costs that can be saved by not adopting a
given alternative, whereas unavoidable costs cannot be saved.
• Avoidable/unavoidable costs are alternative terms sometimes used to
describe relevant/irrelevant costs.

Relevant and irrelevant costs and revenues

• Relevant costs and revenues are those future costs and revenues that
will be changed by a decision, whereas irrelevant costs and revenues
will not be changed by a decision.
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Sunk costs
• Sunk costs are the costs of resources already acquired and are
unaffected by the choice between the various alternatives (e.g.
Depreciation).
• Sunk costs are irrelevant for decision-making.
Opportunity costs
• A cost that measures the opportunity that is lost or sacrificed when
the choice of one course of action requires that an alternative course
of action be given up.
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Example
To produce product X requires that an order that yields $1 000
contribution to profits is rejected. The lost contribution of $1 000
represents the opportunity cost of producing product X.

Marginal and incremental costs/revenues

• Incremental costs and revenues are the additional costs/revenues
from the production or sale of a group of additional units.
• Marginal cost/revenue represents the additional cost/revenue of one
additional unit of output.
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Maintaining a cost database
A cost and management accounting system should generate information
for meeting the following requirements:
1.Inventory valuation for internal and external profit measurement
2.Provide relevant information to help managers make better
decisions
3.Provide information for planning, control and performance
measurement
A database should be maintained, with costs appropriately coded and
classified so that relevant information can be extracted to meet each of
the above requirements.
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1.5 Coding of costs in the accounting system
It is universal practice in accounting systems to use coding systems to refer to
customers, suppliers, accounts and employees. Codes are used because they
are concise and precise, and can be subject to computer checking.
Concise: instead of referring to a product as a “50cm, high resolution LED
monitor”, the product is given a code such as 50HRL. This is much quicker to
write or type.
Precise: there might be several makes of 50cm high resolution LED monitors
and information might be confusing and ambiguous if the manufacturer
(Sony, Panasonic, Samsung, LG e.t.c) wasn’t specified. A code number can
therefore be used to ensure that products and people are referred to
uniquely e.g. 50HRLLG.
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Checking: if all inventory codes are 7 digits long then forms and input screens
can be designed for this. Computers can check that all 7 digits are present;
sometime more sophisticated checks can be carried out on the structure off the
code. This reduces the chance of errors
Processing: Codes can also help in processing transactions. For example if all
income-related accounts have the structure 1xxxx, all expense-related accounts
have the structure 2xxxx, all asset-related accounts 3xxxx and all liability
accounts 4xxxx, then this will help the production of the income statement (all
1xxxx amounts less all 2xxxx amounts) and the statement of financial position
(3xxxx as asset amounts and 4xxxx amounts as liabilities). This is particularly
needed in computerised accounting systems because the computer cannot
understand that, say, rent is an expense, but doesn’t need this understanding so
long as rent is coded, say 21892. Because it starts with ‘2’ it will be treated as an
expense.
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Different methods of coding
There are several methods of coding. Codes should be:
• Simple to use
• Understandable
• Concise
• Precise
• Expandable
As we will see, these requirements can be in conflict.
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Sequential codes
In this method products or customer are simply allocated numbers in sequence:

0001 Abrahams
0002 Adkins
0003 Ahmad

It is simple and concise, but as constructed might have some faults:

1. There is no relationship at all between the code and the item/person being
encoded .
2. Expansion might be difficult once you have over 9999 customer if documents and
computer files can hold only four digits. Additionally, if someone called Affleck
becomes a customer, he will have to be tagged onto the end of the sequence i.e.
not reflecting alphabetical order. To avoid this problem, often sequence codes
proceed as 0010, 0020, 0030…etc so that gaps are built in for future use.
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Hierarchical (or significant digit) codes
Here, are you progress through the code, information become
increasingly specific. Many libraries use this system to code their books
using the Dewey Decimal System
510 Mathematics
520 Astronomy & allied
sciences
530 Physics
540 Chemistry & allied sciences
550 Earth sciences
560 African languages
570 Life sciences
580 Botanical sciences
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In a business, hierarchical codes could be used to code the accounts in the general ledger.
For example a code such as 3112 could be interpreted as the Machinery Cost Account,
using the following system.
3 1 1 2

1 = expenses 1 = non-current assets 1 = cost 1 = property

2 = income 2 = current assets 2 = accumulated 2 = machinery
3 = assets depreciation 3 = office equipment
4 = liabilities 4 = motor vehicles

The great advantage of this type of code is that its structure provides information both to
human users and to computers. For example, it would be easy to program the compute to
work out the total cost of all fixed assets: simply add up all accounts starting 311.
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Block codes
These lie somewhere between simple sequence codes and the full,
detailed hierarchical code. They start off giving some information but
then lose enthusiasm. So for general ledger codes you might have
1xxx = expenses
2xxx = income
3xxx = assets
4xxx = liabilities
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Faceted codes
These are an improvement of block codes and provide more
information but lack a logical hierarchical structure. The code is broken
down into sections or groups of digits and each group codes for a
particular attribute.
For example and employee code could be:
Facet 1 Sex of employee 1= male; 2 = female
Facet 2 Department 01 = accounts; 02 = sales; 03 = IT e.t.c Facet 4 Full or
part time 1 = full time; 2 = part time
Facet 5 Weekly or monthly paid: 01 = weekly; 02 = monthly
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Mnemonic
All the codes illustrated do far have been purely numerical. Mnemonic
codes contain letters to help humans to learn what the codes mean.
The hierarchical code above:
3 1 1 2
1 = expenses 1 = non-current 1 = cost 1 = property
2 = income assets 2 = accumulated 2 = machinery
3 = assets 2 = current assets depreciation 3 = office
4 = liabilities equipment
4 = motor vehicles

Could then become as on the next slide

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A N C M
E = expenses N = non-current C = cost P = property
I = income assets A = accumulated M = machinery
A = assets C = current assets depreciation O = office equipment
L = liabilities M = motor vehicles

It is not common to have full mnemonic codes and often just the first
character will be mnemonic and the rest will follow another system.
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Identifying and correcting errors in coding of revenue and expenses
• Identifying errors in sequence codes is almost impossible because
there is no logical connection between the code and the object or
person that can be used to spot an error.
• The only type of error that can really be identified is if the format of
the code is wrong. For example, 4 or 6 digits are used when only 5 are
expected
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Example
A company uses the following hierarchical system:
1st digit 2nd digit 3rd digit 4th digit

1 = expenses 1 = non-current 1 = cost 1 = property

2 = income assets 2 = accumulated 2 = machinery
3 = assets 2 = current assets depreciation 3 = office
4 = liabilities equipment
4 = motor vehicles

Which of the following correctly codes for the accumulated

depreciation on cars?
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1.6 Costing behavior and estimation
The relationship between cost estimation, cost behavior and
cost prediction.
Cost Estimation Cost Behavior Cost Prediction

For managers to predict how costs will be affected by changes

in an organization, they must understand the relation between
these three categories and use a little magic
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Costing behavior and estimation Continue
Cost Behavior Patterns
• Total variable cost increases in direct proportion to the change in
activity level, but the variable cost per unit remains constant.
• Fixed cost per unit decreases as the activity level increases, but the
total fixed cost remains constant.
• A semi-variable cost has both a fixed and a variable component.
• A relevant range is the range of activity within which management
expects the organization to operate.
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1.6 Costing behavior and estimation cont….
Cost Definitions
• An engineered cost results from a definitive physical relationship with
the activity measure. (e.g. direct raw materials)
• A committed cost results from an organization’s ownership or use of
facilities and its basic organization structure. (e.g. property taxes and
building depreciation)
• A discretionary cost results from a discretionary management decision
to spend a particular amount of money. (e.g. research & development)
• Discretionary costs can be changed in the short run much more
easily than committed costs.
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Cost Estimation
• Cost estimation is the process of determining how a particular cost
behaves.
• The cost analyst classifies each cost item in the ledger as variable,
fixed or semi-variable.
• The two common methods to estimate cost we will consider in AC
207 are:
1. High-low method
2. Learning curves
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High-low method
• We assume always that there are two types of costs – variable costs
and fixed costs. In practice, there are many costs which are semi-
variable, i.e. part of the cost is fixed and part variable.
• For cost estimation (i.e. for in budgeting) purposes it is important to
identify the variable and the fixed elements.
• The high-low method is a very quick and simple approach to
identifying the variable and fixed elements of costs.
• This approach assumes that there is a linear relationship and uses just
the highest and lowest observations in order to calculate the costs.
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High-low method
Example 1
The following table shows the number of units produced each month and the
total cost incurred:
Units Cost ($)
January 100 40,000
February 400 65,000
March 200 45,000
April 700 85,000
May 600 70,000
June 500 70,000
July 300 50,000

Estimate the variable cost per unit, and the fixed cost per month
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High-low method
ANSWER TO EXAMPLE 1
units $
High 700 85,000
Low 100 40,000
600u $45,000
Variable cost = 45,000 = $75
600
For high:
Total cost = 85,000
Variable cost (700u @ $75) 52,500
Fixed cost $32,500
This approach is very simplistic. It assumes that the relationship is perfectly linear.
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Learning curves
• As seen previously high-low method assumes that the total variable cost
is reasonably linear – that the variable cost per unit is fixed. In the case of
labour, this is very often not the case in the early stages of a new product.
• If we were intending to start production of a new product, then the
obvious thing to do would be to produce a prototype in order to assess
how long it would take to produce each unit. However, this would be
dangerous because as we were to produce more and more units it is likely
that the time taken for each unit would reduce as the workers gained
experience.
• This reduction in time per unit is known as the learning effect.
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Learning curves
Conditions
The theory of learning curves will only hold if the following conditions apply:
(1) There is a significant manual element in the task being considered.
(2) The task must be repetitive.
(3) Production must be at an early stage so that there is room for
improvement.
(4) There must be consistency in the workforce.
(5) There must not be extensive breaks in production, or workers will ‘forget’
the skill.
(6) Workforce is motivated.
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Learning curves cont…
The Theory
• As cumulative output doubles, the cumulative average time per unit
falls to a given percentage of the previous average time per unit.
Example 2
The time taken to produce the first unit is 100 hours. There
is a learning rate of 75%.

How long will it take to produce an additional 7 units?

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Learning curves
ANSWER TO EXAMPLE 2
units Average time Total time
1. 100 100
2. 75 150
4. 56.25 225
8. 42.1875 337.5
hours
Time for 8 337.5
Time for first 100
Time for additional 7 237.5 hours
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Learning curves cont…
Steady State
• Eventually, the time per unit will reach a steady state where no
further improvement can be made.
Cessation of learning effect
Practical reasons for the learning effect to cease are:
(a) When machine efficiency restricts any further improvement
(b) The workforce reach their physical limits
(c) If there is a ‘go-slow’ agreement among the workforce
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Learning curves
Formula
y = axb
where
y = cumulative average time per unit
x = cumulative output
a = time taken for 1st
b = a learning factor which is given by the formula:
log r
log 2
r = learning rate expressed as a %.
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Learning curves
Example 3 Flogel Ltd has just produced the first full batch of a
new product taking 200 hours. Flogel has a learning curve
effect of 85%.
(a) How long will it take to produce the next 15 batches?
(b) Flogel expects that after the 30th batch has been
produced, the learning effect will cease.
From the 31st batch onwards, each batch will take the same
time as the 30th batch.
What time per batch should be budgeted?
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NEXT CHAPTER LOOKS AT ACCOUNTING FOR OVERHEADS