LECTURE ONE

INTRODUCTION TO COST ACCOUNTING

1.1 Lecture Overview

Welcome to Cost Accounting course. This course is important in every sector whether
manufacturing or service, and help in communicating financial information to management for
planning, evaluating and controlling performance, and also to assist management to make more
informed decisions in line with the changing environment. Costing as is normally referred is
one of the courses that you will always need in all aspect of your life and profession. As a
result, cost accounting is taught to all students irrespective of their profession and areas of
specialization. It is therefore important that as cost accounting students you understand the
important concepts in this class. This lecture will introduce you to “what we mean by cost
accounting”.

1.2 Objectives

By the end of the topic, you should be able to:

i. Define cost accounting;
ii. Outline the relationships of cost accounting to management accounting and financial
accounting;
iii. Describe the role of a cost accounting department in an organization;
iv. Describe the various cost classifications and prepare a cost statement.

1.3 Definition of and Scope of Cost Accounting

Cost accounting is concerned with the ascertainment of costs. It is that part of management
accounting which establishes budgets and standard costs and actual costs of operations,

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processes, departments or products and the analysis of variances, profitability or social use of
funds”.

Cost accounting identities, defines, measures, reports and analyses the various elements of
direct and indirect costs associated with producing and marketing goods and services. Cost
accounting also measures performance, product quality and productivity”. It is a systematic
process of collecting, summarizing and recording data regarding the various resources and
activities in a firm so as to calculate the basis of production costs used in financial accounting
or making other relevant decisions in a firm.

Cost accounting is broad and extends beyond calculating production costs for inventory
valuation, which government-reporting requirements largely dictate. However accountants do
not allow external reporting requirements to determine how they measure and control internal
organizations activities. It focuses in shifting from inventory valuation for financial reporting
to costing for decision making.

The main objective of cost accounting is communicating financial information to management

for planning, evaluating and controlling performance, and also to assist management to make
more informed decisions. Its data is used by managers to guide their decisions.

1.4 The Relationship of Cost Accounting and Other Accounting Disciplines

Accounting can be described as a specialized information system that is used for purposes of
decision making by the management of the organization and other users such as tax authorities,
investors, creditors and the general public. Accounting is broadly divided into two:
i. Financial accounting
ii. Management accounting

1.4.1 Financial accounting

This is the analysis, classification and recording of financial transactions and the
ascertainment of how such information will be reported to the various users. It involves the
development of general-purpose financial statements largely for external reporting. These

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 statements are developed in accordance with standards imposed by the public (through the
professional accounting bodies such as the Institute of Certified Public Accountants of Kenya –
ICPAK and the International Accounting Standards Board – IASB) as well as the requirements
of the Companies Act Chapter 486.

Conditions for effective costing system

Costing system must be simple, economical and practical. The conditions for an effective and
successful costing system include:-
i. Proper system of stores and stock control;
ii. Co-operation and co-ordination among the staff members;
iii. Proper and satisfactory wage procedures;
iv. Proper record keeping e.g., receipt of materials, issue of materials, labour hours worked,
wage calculations etc;
v. The overheads must be recorded accurately and these must be charged to the respective
production departments;
vi. The cost accounting department must be established e.g., have cost accountants;
vii. The cost accounts and financial accounts should be maintained in such away that their
results can be reconciled easily.

Examples of information provided by a typical costing system and how it is used are given in
the following table:

Information provided by costing system Possible uses by management

Cost per unit of production or service or for As a factor in pricing decisions, production
a process planning and cost control

Cost of running a section, department of Organization planning, decisions on

factory alternative methods, wages cost control

Wages costs for unit of production or per Production planning, decisions on

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period of production. alternative methods, wages cost control

Scrap/rectification costs Material cost control, production planning

Cost behaviour with varying levels of Profit planning, make or buy decisions, cost
activity

Activity 1.1

As you will realize as you go through this course, the characteristics of a good
cost accounting system should be simple,economical and practical. Identify what may be
hindering good costing systems in your organisation?

An important part of the management task is to ensure that operations, departments, processes
and costs are under control and that the organization and its constituent parts are working
efficiently towards agreed objectives. Although there are numerous other control systems
within an organization, for examples: production control, quality control, inventory control, the
costing system is the key financial control system and monitors the results of all activities and
all other control systems. The detailed analysis and location of all expenditures, the calculation
of job and product costs, the analysis of losses and scrap, the monitoring of labour and
departmental efficiency and outputs of the costing system, provide a sound basis of
information for financial control.

Financial accounting can be defined as: The classification and recording of the monetary
transactions of an activity in accordance with established concepts, principles, accounting
standards and legal requirements and their presentation, by means of profit and loss account,
balance sheets and cash flow statements, during and at the end of accounting period’. Financial
accounting originated to fulfill the stewardship function of businesses. Most of the external

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financial aspects of the organization, e.g., dealing with accounts payable and receivables,
preparation of final accounts etc., are dealt with by the financial accounting system. Of course
internal information is also prepared, but in general it can be said that financial accounting
presents a broader, more overall view of the organization with primary emphasis upon
classification according to type of transaction. However, the cost and management accounting
emphasis on the function, activities, products and processes and on internal planning as well as
control information.

1.5 Distinction between Financial Accounting and Management Accounting

Financial accounting and management are two interrelated facets of the accounting system.
They are not exclusive of each other; they are supplementary in nature. Financial accounting
provides the basic structure for collecting data. The data collection structure is suitably
modified or adjusted for accumulating information for management accounting purpose. In a
broader sense, management accounting includes financial accounting. A distinction is drawn
between financial accounting and management accounting since they differ in their emphasis
and approaches. Some of the characteristics which distinguish management accounting and
financial accounting are discussed below:

Focus - Financial accounting emphasizes the external use of accounting data. Management
accounting on the other hand, utilizes accounting data for internal use. The major objective of
financial accounting is to prepare balance sheets and profit and loss account to inform
shareholders and others about the firm’s profitability and the state of its resources and
obligations. Management accounting however, collects and reports relevant information for
making decisions thus ensuring optimum use of the firm’s resources.
.
Principles - The accounting profession has developed certain principles for preparing and
presenting financial reports for external uses. Financial accounting adheres to these generally
accepted accounting principles. It introduces consistency and meaningfulness of data for the
investors’ point of view. They can make inter firm comparisons of performance and analysis
performance trend over years when accepted principles are followed by all firms. Management
accounting, however, is not based on any set of accepted rules of principles. Every enterprise,

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depending on its requirements for facts, evolves its own procedures and principles for
preparing reports for internal uses.

Information - Financial accounting accumulates and reports historical information to

investors.. Through balance sheets and profit and loss accounts, it reveals to the investors what
they are entrusted to in terms of what the firm has utilized. Management accounting, being a
decision-making process, focuses on the future. It analyses past data and adjusts them in the
light of future expectations to make plans.

Need - Financial accounting is an outcome of statute. For example, in India under the
companies Act, it is used to prepare balance sheet and profit and loss account for submission to
shareholders and others. The financial statements are generally required to be prepared in the
formats prescribed by the law. Management accounting is the result of the management’s needs
of information for making decisions. It is, therefore, optional. Management accounting
functions differ from firm to firm. A firm may have a sophisticated elaborate and
comprehensive system while another may have a partial system only.

Timing - Financial accounting adopts twelve months (one year) period for reporting financial
performance to shareholders and other investors. In contrast, management accounting reports
are meant for shorter durations. For instance, some companies in India prepare daily budgets.
Monthly and quarterly reports are quite common. However, management accounting
expenditure plans, for example, cover a longer duration.

Coverage - While reporting the state of affairs of a company, financial accounting covers the
entire organization. Financial statements show revenue, expenses, assets and equities of the
firm as a whole. For management accounting purpose, however, organization is divided into
smaller units, or centres. These centres may be headed by responsible persons. Cost data and
other information’s are collected and reported by the centres. Thus, the data requirements of
management accounting are more specific.

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Reporting - Financial statement-balance sheet and profit and loss account – are subject to the
verification of statutory audit. Therefore, financial accounting stresses accuracy and precision
of accounting data. Management accounting requires information promptly for decision-
making. Continuous and speedy flow of approximate information is more useful than the
precise, but delayed information.

1.5.1 Management accounting

Management accounting is defined as: ”The application of professional knowledge and skill in
the preparation and presentation of accounting information in such a way as to assist
management in the formulation of policies and in the planning and control of operations of the
undertaking”. The provisions of information required by management for such purposes
include:
a. Formulation of policies;
b. Planning and controlling the activities of the enterprise;
c. Decision taking on alternative courses of action;
d. ]disclosure to those external to the entity;
e. Disclosure to employees;
f. Safeguarding assets.

Management accounting uses both financial and cost information to advice management in
planning and controlling the organization. The objectives of the various facets of accounting
have been mentioned above and their differences. However, it must be realized that all form
part of the financial information system of an organization and in many organizations, the
various facets are totally integrated with no artificial divisions between them.

Management accounting provides special - purpose statements and reports to management

and other persons inside the organization. The information generated by is therefore for
internal uses and is not guided by any standards or legal requirements. Management
accounting, unlike financial accounting, is proactive i.e., it is future-oriented. It is required in
making decisions that affect the organization.

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In a nutshell, cost accounting enables a business not only to find out what various jobs or
processes have cost, but also what they should cost. It indicates where losses are occurring
before the work is finished and therefore corrective action can be undertaken. From the
foregoing discussion, it is then clear that cost accounting is very closely related to other
accounting subjects especially management accounting. In fact, most people make no
distinction between management accounting and cost accounting.

1.5.2 Relationship between cost accounting and management accounting

Referring to CIMA’s definition of cost accounting, we can see that cost accounting is a part of
management accounting.
CIMA defines management accounting as “provision of information required by the
management for such purposes as formulation of policies, planning and controlling the
activities of the enterprise, decision taking on the alternative courses of action, disclosure to
those external to the entity (shareholders and others), disclosure to employees and
safeguarding assets. Cost accounting and management accounting have basically the same
functions.

1.6 Purpose of Cost Accounting Information

Cost Ascertainment - Costs relating to materials, labour and overhead costs must be
ascertained accurately. They should be kept at minimum level possible.
Disclosure of Wastes - The costs incurred for the production of any commodity can be
determined in advance in view of the past experience. If the actual costs are higher than the
expected or standard costs, then this excessive cost can be analyzed e.g., it may be from
wastage of raw materials, idle labour, time wastage etc.
Decision Making - Cost accounting provides necessary information to the management for
decision making e.g., what goods to produce and in what quantities.
Cost Control - Materials costs, labour costs and overheads must be maintained at desirable
levels. Cost accounting principles are used to eliminate unnecessary costs.
Planning - The cost data and past experience are used to prepare and implement future plans
e.g. expansion of business.

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Measurement of Efficiency -Departmental performance can be measured using the costs data.
More efficient departments will be given greater incentives and appropriate steps taken to
improve the performance of less efficient departments.

1.6.1 Settling selling prices

A business concern must ascertain its cost and then add its profit into cost of sales to avoid
charging high or low prices which can bring negative effects.

Evaluation of profitability
Profitability can be measured in a number of ways e.g., profit as a percentage of sales, profit
percentage to capital employed, profit per unit of output etc. The profitability information
serves as a guide to the management to make some strategic decisions regarding the
introduction of new products and increasing or decreasing the volume of production.
a) Accounting for costs
This may be seen as a record keeping or score keeping role. Information must be gathered and
analyzed in a manner which will help in planning, control and decision making.
b) Planning and budgeting
This involves the quantification of plans for the future operations of the enterprise e.g., long or
short term plans, for the enterprise as a whole or for the individual aspects of the enterprise.
c) The control of the operations of the enterprise
Control may be assisted by the comparison of actual cost information with that included in the
plan. Any differences between planned and actual events can be investigated and corrective
action implemented as appropriate.
d) Decision making
Cost accounting information assists in the making of decisions about the future operations of
the enterprise; such decision making may be assisted by the information from cost techniques
and cost-volume – profit analysis.
e) Resource allocation decisions
A good example is product pricing in determining whether to accept or reject jobs: This is
based on cost and revenue implications of the relevant decisions
f) Performance evaluation

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Cost accounting information is used to measure and evaluate actual performance so as to make
a decision of the degree of optimality or efficiency of resource utilization.

1.6.2 The role of a cost accounting department in an organization

As part of their jobs, cost accountants interpret results, report them to management and provide
analysis that assist decision-making in the following departments:
a. Manufacturing
Cost accountants work closely with production personnel to measure and report manufacturing
costs. The efficiency of the production departments in scheduling and transforming materials
into finished units is evaluated for improvements.
b. Engineering
Cost accountants and engineers translate specifications for new products into estimated costs;
by comparing estimated costs with projected sales prices, they help management decide
whether manufacturing a product will be profitable.
c. Systems design
Cost accountants are becoming more involved in designing computer integrated manufacturing
(CIM) systems and databases corresponding to cost accounting needs. The idea is for cost
accountants, engineers and system designers to develop a flexible production process
responding swiftly to market needs
d. Treasury
The treasurer uses budgets and related accounting reports developed by cost accountants to
forecast cash and working capital requirements. Detailed cash reports indicate where there are
excess funds to invest or where cash deficits exist and need to be financed.
e. Financial accounting
Cost accountants work closely with financial accountants who use cost information in valuing
inventory for external reporting and income determination purposes.
f. Marketing
Marketing is done by the cost accountant during the product innovation stage, the
manufacturing planning stage and the sales process. The marketing department develops sales
forecast to facilitate preparing a products manufacturing schedule. Cost estimates, competition,

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supply, demand, environmental influences and the state of technology determines the sales
price that the product be offered and will command in the market.
g. Personnel
Personnel department administers the wage rate and pay methods used in calculating each
employees pay. This department maintains adequate labour records for legal and cost analysis
purposes.At this point, it cannot be over-emphasized that cost accounting is simply an
information system designed to produce information to assist the management of an
organization in planning and controlling the organisation’s activities. It also assists the
management to make informed decisions so as to enable the organization to operate at
maximum effectiveness and efficiently.

1.6.3 Role of Cost Accounting in Business Management

A system is a set of interdependent parts which together form a unitary whole that performs
some functions. A number of sub-systems make up the whole. In this context of the
organization, a management information system may be seen as the overall system with a
number of sub systems including the cost and management accounting system that provide the
information to management for purposes of planning, organizing, directing and controlling the
organization’s activities so as to achieve corporate goals including profit maximization.

Information must be collected, processed and communicated in an organized manner if the

objectives of the enterprise are to be efficiently implemented and alternative strategies for their
implementations examined, so as to select the best strategy. Information may be non-mutually
exclusive in nature. This means that information gathered as part of the management
information system may be used in two or more subsystems for differing purposes. An
example of this information is with regard to the amount and location of work in progress:
work in progress refers to partly completed units of products where a product passes through a
number of operations and processes before being passed into finished goods store or to the
customer. This information may be used by:
a) Production planning department in order to monitor the progress of parts of an order
through the production process and to instigate action to speed up the completion of slow
moving parts of the order.

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 b) Quality control department in comparing one batch of product with another in
highlighting the incidence of process losses and their location.
c) Cost management department in the quantification and valuation of actual loses as
compared to the level originally allowed for in the business plan.
d) Financial accounting department in the valuation of work in progress for balance sheet
purposes and for purposes of determining the cost of sales in the income statement.

Activity 1.1

Review ways in which you can use cost accounting in your home and organization i.e units
departments, products and process.

1.7 Summary

i. Cost accounting is concerned with the ascertainment and control of costs

ii. The purpose of cost accounting is to provide detailed information for control, planning
and decision making.
iii. Costing information must be appropriate, relevant, timely, well presented and sufficiently
accurate for the purpose intended.
iv. Cost accounting and management accounting are closely related.
v. The emphasis of financial accounting is upon classification by type of transaction and
expenditure rather than the functional analysis of cost accounting.
vi. Cost, financial and management accounting all contribute to the financial information
system of an organization and increasingly in practice are totally integrated.

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1.8 Self-Assessment Questions

1. Define cost accounting

2. Give six examples of costing information and its uses
3. What is the relationship between costing, management accounting and financial
accounting?
4. Describe the main purposes of cost accounting
5. Define the following terms
a) Cost accounting
b) Financial accounting
c) Management accounting

6. Briefly describe the purpose of cost accounting.

7. Compare and contrast cost accounting and financial accounting

1.9 Further Reading

1. Paresh, S. (2010). Cost Accounting. 3rd Edition, Tata McGraw-Hill, New Delhi.
2. Lucy, T. (2009) Costing. 9th Edition, Book Power, London
3. Saleemi, N.A. (2009) Cost Accounting Simplified, N.A Saleemi Publishers, Nairobi
4. Drury C., (2004) Management and Cost Accounting. 6th Edition, Book Power, London.

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