Chapter 1: Conceptual Framework of Cost and Management Accounting

Cost Accounting: Meaning And Scope

Cost accounting can be defined as a system in which financial data regarding business transactions are collected, classified, recorded, evaluated and reported for the following three purposes:

• To find the cost of product or service,
• Planning and controlling activities,
• Decision-making process

Determining Product Costs and Pricing

Unit cost information is also helpful in making important marketing decisions such as determining the selling price of a product, meeting competition, bidding on contracts, and analyzing profitability.

Planning and Control

Planning is the process of establishing objectives or goals for the business and calculating the means by which they will be met. Effective planning is made easier by clearly defined objectives and a production plan.

Control is the process of monitoring the company’s operations and determining whether the objectives identified in the planning process are being accomplished. Effective control is achieved by assigning responsibility, periodical measuring and comparing of results, and taking necessary corrective action.

Concepts of Cost Accounting

Cost is a resource sacrificed or forfeit to achieve a specific objective. A factual cost is a cost incurred, as a budgeted cost, which is a predicted or forecasted cost.

The concept of expense is more comprehensive than the concept of cost. We use the cost to refer to an item that still has service potential and is an asset. We use the expense after the organization has used asset’s service potential.

Often costs are assigned to the same kind of groups called cost pools. Costs can be grouped in many different ways, including type of cost (labor costs in one pool, material costs in another), source, or responsibility.

A cost driver is any factor that has the effect of changing the amount of total cost. A cost object is an item or activity for which we measure costs. If the users of accounting information want to know the cost of the item, this item is called a cost object. A costing system typically accounts for costs in two basic stages:

• Cost accumulation: the collection of cost data in some organized way by means of an accounting system.
• Cost assignment: a general term that includes both (1) tracing accumulated costs that have a direct relationship to a cost object and (2) allocating accumulated costs that have an indirect relationship to a cost object.

Direct and Indirect Costs

• Direct costs: These are the costs that are directly identified with a cost object. Cost of direct material and direct labor sustain in producing a product. These costs are also named as a variable cost. The term cost tracing is used to describe the assignment of direct costs to a cost object.
• Indirect costs: These are the costs that are not directly identified with a cost object. Production costs not easily associated with the production of specific goods or services. This concept is also used as an overhead cost. The term cost allocation, is used to describe the assignment of indirect costs to a cost object.

Direct costs can be precisely traced because they can be physically identified with a particular object but indirect costs cannot.

See Figure 1.1 on page 6 of the book for cost assignment to a cost object.

Manufacturing Costs and Period Costs

Manufacturing (product) cost is grouped under three headings:

• Direct raw material cost
• Direct labor cost
• Manufacturing (factory) overhead cost

The raw material and supplies costs are classified under two headings. The first classification is the direct raw material cost. The second classification is indirect raw material and supplies cost.

Direct raw materials are the raw materials that enter into the structure of the product produced, which constitute the basic structure of the product and which can be used for which product or product group can be monitored.

Indirect raw material and supplies costs are the raw materials and materials which are used in production and do not constitute the basic structure of the product. These costs are tracked under manufacturing overhead costs.

Labor costs are classified under two headings. The first classification is the direct labor cost. The second classification is the indirect labor cost.

The labor which is used to produce the product or service that constitutes the basic production subject of the enterprise and which can be directly loaded to the cost of the product or service produced is defined as direct labor. Indirect labor is the labor which is used in production and cannot be put directly into the products or services produced outside of labor costs. These costs are tracked under manufacturing overhead costs. Direct labor cost combined with the direct material cost is called prime cost.

The manufacturing overhead costs consist of a combination of many different cost elements. All costs related to production other than direct raw materials and direct labor are under this heading. Manufacturing overhead cost includes items such as indirect raw materials, indirect labor, depreciation expenses of fixed assets used in production, insurance, tax and rent expenses of fixed assets used in production, energy and fuel costs used in production and service expenses. Manufacturing overhead cost combined with direct labor cost is called conversion cost.

Total manufacturing costs are calculated in the total cost of direct raw material, direct labor cost, and manufacturing. Unit cost is the total manufacturing cost divided by the number of units of output.

Other than manufacturing costs, there are also expenses. Period expenses are recognized as an expense in the period in which they are consumed and transferred to the income statement. These expenses consist of administrative expenses, marketing expenses, and similar nonmanufacturing expenses, and the cost of goods sold for the purpose of revenue.

Non-manufacturing expenses are:

• Marketing or selling expenses
• Administrative expenses

The treatment of period expenses and product cost for a manufacturing organization is illustrated in Figure 1.2 on page 8 of your book.

Cost Behaviour

Cost behavior is defined as the functional relationship between changes in activity and changes in cost. The ability to analyze cost behavior requires knowledge of an organization’s economic environment and operations.

A relevant range is defined as an area of activity in which the cost behavior does not change.

Variable, Fixed and Mixed Costs

Variable costs represent cost behavior that is directly related to changes in the volume of operations and increases when the volume of activity increases and is zero.

Fixed costs are defined as costs that are not affected by changes in operating volume at least in the short run. Some fixed costs are easy to classify, such as rent, insurance, and property taxes.

Many costs in practice are mixed costs; they are partly fixed and partly variable. In the literature, mixed costs are covered under two categories:

• Semi-fixed costs: This cost can be defined as a cost which shows the characteristics of fixed costs initially and it jumps to a higher point when the quantity increases and shows against the characteristics of fixed cost until production amount changes.
• Semi-variable costs: This cost can be defined as a cost that includes both fixed and variable cost.

Cost Function

A cost function is a mathematical formula used to chart how production costs will change at different production levels. By using this function, the expected (estimated) total costs for different activity volumes are determined and compared with the actual values.

Cost functions are usually based on two assumptions (Datar and Rajan, 2018, 393):

1. Variations in the level of a single activity (the cost driver) explain the variations in the related total costs.
2. Cost behavior is approximated by a linear cost function within the relevant range. For a linear cost function, the total cost versus the level of a single activity related to that cost is a straight line within the relevant range. We write the linear cost function as:

y = a + bx

y: cost function b: unit variable cost x: activity volume a: fixed cost

Inventoriable Costs and Product Cost Flows

Enterprises are classified under three headings (Horngren, Datar and Foster, 2005: 36):

• Manufacturing-sector organizations purchase raw materials and supplies and convert them into various finished goods(automative, furniture companies…).
• Merchandising-sector organizations purchase and then sell tangible products without changing their basic form(retailing, distribution, whosesaling).
• Service-sector organizations provide services(law firms, insurance companies, travel agencies…)

Inventoriable Costs

Manufacturing-sector organizations purchase raw materials and supplies and convert them into various finished goods. There are three important inventory items in manufacturing organizations; 1) raw material and supplies inventory 2) work-in-process inventory 3) finished goods inventory

Product Cost Flows

See figure 1.3 on page 14 of your book for an illustration of the flow of costs in a manufacturing company.

Management Accounting: Meaning and Scope

Management accounting is an information system that provides financial and non-financial data to be useful for managers to make decisions. Management accounting has a much broader perspective than cost accounting. Management accounting focuses on strategic planning, resource allocation, cost planning and control, and performance measurement.

Meaning and Importance of Management Accounting

Management accounting information has the following features:

1. Managerial accounting provides both data on past transactions and helps users with information and calculations for the future.
2. Management accounting has a multifaceted perspective by meeting the needs of decisionmaking of both employees and senior management
3. Management accounting, as in financial accounting, does not analyze within the framework of various theoretical rules or legal regulations.

Management Accounting as an Information System

The quality of the service provided would be determined by the extent to which the managers’ information needs have been met. Management accounting information system has many key qualities such as relevance, reliability, comparability and understandability.

The managerial accounting information system has certain characteristics as in the same business information systems. These are:

• Identifying and capturing relevant information,
• Recording the information collected in a systematic method,
• Analyzing and interpreting the information collected,
• Reporting the information in a method that suits the needs of individual managers

Use of Management Accounting Information System in Decision Making

The areas of management accounting in decision-making are

• Developing objectives and plans
• Performance evaluation and control
• Allocating resources
• Determining costs and benefits

Management Accounting, Financial Accounting, and Cost Accounting

The users of accounting information can be divided into two categories (Drury, 2012: 6):

• Internal users within the organization,
• External users such as shareholders, creditors, and regulatory agencies, outside the organization.

Financial accounting focuses on external reporting that is directed by authoritative guidelines. Therefore, financial accounting provides information to external users.

Cost accounting measures and reports financial and nonfinancial information related to the organization’s acquisition or consumption of resources. It provides information for both management accounting and financial accounting.

Differences Between Management Accounting And Financial Accounting

• Legal requirements: Except forexceptional cases in financial accounting, the operating period is one year and the reports are issued on an annual basis. In the management’s accounting, the information to be used in the business decisions can be organized in the form of 10-15 years, one year, six months, monthly, weekly, even daily and hourly reports. In management accounting, it is possible to use standard costs, sales forecasts, production quantities, customer satisfaction and so on. The important point in managerial accounting is that documents do not prove for legal requirements but provide useful information for managers.
• Focus on individual parts or segments of the business: The main users of financial accounting are non-business users such as state, banks, potential investors, shareholders. Managerial accounting primarily provides information to managers within the business.
• Generally accepted accounting principles: Although the data used in financial accounting is in monetary amounts, the amounts of production, the quantity of orders, completion percentages and similar physical measurement units can be used in management accounting. Therefore, there is an obligation to comply with generally accepted accounting principles, tax laws, Turkish Commercial Code and all related laws and regulationsin financial accounting. There is no such requirement in managerial accounting, but voluntary commitment is essential.
• Time dimension: Financial accounting records and reports past financial transactions, in which the report is retrospective. At the decisionmaking stage, managers want to know the expected cost and income amounts in the future. Thus, managers will minimize the risk of decision making. Management accounting provides managers with all kinds of information they need to make decisions. In managerial accounting, data based on prediction as well as the use of past financial data are analyzed and interpreted.