Exciting New Resources

Dear Readers,
We are excited to announce major updates in this new edition of
the book (fifth edition):

● A new chapter discussing the importance of customer

relationship management (CRM) to the overall financial
success of the organization has been added. This chapter
also explores the topic of customer profitability analysis and
its significance for the organization.

● The content of each chapter has been fully updated

and reflects the current trends in cost accounting and
management.

● Additional problem-based exercises have been included on

the basis of real-world problems that many professionals
face in the workforce. This 5th edition also contains many
case studies that highlight real-world problems and current
affairs.

● This 5th edition has more content coverage, which will

appeal to modern students interested in reading relevant
information about the world of cost accounting and
management.

● This updated edition includes detailed and self-explanatory

solutions to unsolved examples in Practice Exercises. You
may download the solutions at www.vibrantpublishers/
onlineresources

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 TM

SELF-LEARNING MANAGEMENT SERIES

COST ACCOUNTING
AND MANAGEMENT
ESSENTIALS
YOU ALWAYS WANTED TO KNOW

FIFTH EDITION

A simple guide to making managerial decisions based on

cost data

KALPESH ASHAR
Cost Accounting and Management
Essentials You Always Wanted To Know
Fifth Edition

© 2022, By Vibrant Publishers, USA. All rights reserved. No part of this publication
may be reproduced or distributed in any form or by any means, or stored in a database
or retrieval system, without the prior permission of the publisher.

Paperback ISBN 10: 1-63651-103-1

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Hardback ISBN 13: 978-1-63651-105-4

Library of Congress Control Number: 2011928208

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 About the Author
Kalpesh Ashar is a management consultant and
corporate trainer holding an MBA (Dean’s
Award Winner) from SPJIMR, one of Asia’s top
business schools, and an Engineering degree
with honors in Electronics. He has over 24 years
of experience in large organizations and start-
ups in Asia, USA, and Europe.
Kalpesh has worked in several project management roles, like
Senior Project Manager, Delivery Manager, and Program Manager.
He is passionate about writing on management subjects. His
techno-business background gives him a unique position to write
on management topics that are easy to understand for non-MBA
graduates. His books are authored in a simple to understand manner
without unnecessary use of management jargon.
Other contributors
Virginia Eron Frondozo is a Certified Public Accountant and holds
a Bachelor of Science degree in Business Administration. She was.
the head of Cost Accounting in Colgate-Palmolive Philippines, Inc.
and was instrumental in developing her team to assume expanded
roles in the organization to include managerial finance functions.
In mid-2013, Virginia left the corporate world and started accepting
online consultancy engagements ranging from business analysis and
business planning to coaching and tutoring.

Mark Koscinski, a certified public accountant, is an assistant professor

of accounting practice at Moravian University in Bethlehem,
Pennsylvania where he teaches a wide range of accounting courses
and decision analysis. Dr. Koscinski is the author of Decision Making
Essentials You Always Wanted to Know, another book in the Self-
Learning Management Series. He has over 40 years of experience
in accounting and management in the banking, pharmaceutical,
defence contracting and toy industries. Dr. Koscinski has degrees in
economics, accounting, taxation, and personal financial planning. He
also maintains an active consulting practice.
 What experts say about this book!
The book uses charts, graphics, tables and relevant examples to
explain the concepts of cost accounting and also provides a detailed
computation for each of them. Cost Accounting and Management
Essentials is a well-organized book that will help students understand and
conquer the subject easily.

– Jangho Gil, Assistant Professor of Accounting,

Monmouth University Logo

The book is simple to understand, contains a plethora of questions and

answers and is perfect for those who are studying cost accounting as a
non-core subject. This book is broken down into bite-sized pieces so that
the concepts of cost accounting are easy to digest and remember.

– Xihui Chen, Assistant Professor of Accounting and Finance,

Heriot-Watt University
 What experts say about this book!
The book touches upon all the concepts required in cost accounting
without getting into a lot of details. It introduces the readers to a lot of
terminologies when it comes to cost classifications and behaviors.

– Dr Cheryl A Moore, Assistant Professor of Accounting,

Mercyhurst University

This book covers adequate topics that are included in the PG curriculum
in recent years. The theoretical coverage and language of the book is
lucid and student-friendly. The illustrations are better placed and the
book has simple examples that help elucidate the concepts. Overall, the
book offers a clear understanding of cost and management accounting.

– Dr.Chetana Asbe, Faculty of Finance,

Chetana's Institute of Management & Research
 Table of Contents

1 Introduction 1
1.1 Cost Accounting Terms 2
1.2 Using a Costing System 13
Solved Examples 19
Practice Exercise 26
Chapter Summary 29

2 Cost-Volume-Profit (CVP) Analysis 31

2.1 Contribution Income Statement 32
2.2 CVP Analysis 34
2.3 Breakeven Point and Target Income 36
2.4 CVP Analysis for Decision Making 39
2.5 Sensitivity Analysis 44
Case Study 46
Solved Examples 47
Practice Exercise 51
Chapter Summary 54

3 Decision Making using Relevant Information 57

3.1 One-Time-Only Special Orders 59
3.2 Make-or-Buy Decisions 62
3.3 Outsourcing and Opportunity Costs 64
3.4 Product-Mix Decisions with Capacity Constraints 66
Case Study 68
Solved Examples 70
Practice Exercise 76
Chapter Summary 78
4 Activity-Based Costing 79
4.1 Broad Averaging 80
4.2 Simple Costing System 81
4.3 Activity-Based Costing System 85
4.4 Customer Profitability 90
Case Study 94
Solved Examples 96
Practice Exercise 104
Chapter Summary 107

5 Support Department Cost Allocation 109

5.1 Need for Cost Allocation 110
5.2 Cost Allocation Basis 111
5.3 Allocating Costs of One Support Department 111
5.4 Allocating Costs of Multiple Support Departments 116
Solved Examples 123
Practice Exercise 128
Chapter Summary 130

6 Cost Control 131

6.1 Direct Variances 132
6.2 Indirect Variances 138
Solved Examples 142
Practice Exercise 147
Chapter Summary 149

7 Customer Profitability 151

7.1 Why Is Understanding Customer Profitability
So Important? 152
7.2 Customer Information Systems 153
7.3 From Product to Customer Profitability 154
7.4 Activity-Based Costing 156
 7.5 Unprofitable Customers and Products 158
Solved Examples 161
Practice Exercise 164
Chapter Summary 165

Glossary 167
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 Preface
Managers need to make quick and correct decisions on an almost
daily basis. But to make these decisions, they need to understand
various numbers about their business. These numbers are provided
by a cost accounting system. In today’s economic environment,
this kind of decision making is not only limited to the senior
management, but also done by managers and leaders at all levels in
the hierarchy.

Cost Accounting and Management Essentials You Always Wanted

to Know provides that set of bare minimum skills that you need to
understand the costing numbers. It consists of only those key areas
that are considered critical. The objective of the book is not to teach
you everything in costing, but to equip you with enough information
to be more productive and accurate in your decision making, with the
cost perspective in mind.
This page is intentionally left blank
 Who can benefit from the book?
This book can be used by anyone who needs to understand cost
accounting numbers, like:

● Managers in an organization

● Individuals who need to make decisions in an organization

● Senior management of an organization

It can also be beneficial for those interested in the field of cost

accounting, like:

● Students learning costing as part of their university course

● Anyone else who is interested in learning how to read

costing numbers to help in decision making

How to use this book?

The recommended approach to reading this book is to start from
the first chapter and go in sequence, even if you are experienced in
costing. This will ensure that you get a solid base of the previous
chapters that will be needed to understand the later chapters better.
There is a lot of cost accounting terminology in each chapter that
could be new to you, and understanding it will help you with the
later material in the book.
This page is intentionally left blank
Chapter 1

Introduction

I n this chapter, we shall look at the fundamentals

of cost accounting. These form the pillars for our
understanding of the later chapters.

The key learning objectives of this chapter are:

● Learn the different terms used in cost / managerial

accounting

● Understand the different types of costs

● Get introduced to a costing system for decision-making

An accounting system helps capture and organize information

related to business transactions. Depending upon the focus, it can
be divided into two types – Financial Accounting and Managerial
Accounting. A Financial Accounting system contains financial
statements and disclosures meant for decision makers external to
the company. A Managerial Accounting system contains detailed
plans and performance reports meant for decision-makers within
the company.

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2 Cost Accounting and Management Essentials You Always Wanted To Know

Figure 1.1

Accounting Systems

Financial Accounting System Managerial Accounting System

External Decision Makers Internal Decision Makers

Cost Accounting provides information required by both types

of accounting systems. Another term, Cost Management, is also
used frequently. It refers to the approaches and activities adopted
by managers to use the company’s resources to increase the value
given to customers and to achieve organizational goals. It must
be noted that cost management is not synonymous with cost
reduction.

In the later chapters, we shall look at the cost accounting and

cost management aspects of accounting. We shall see how cost
accounting information helps in short-term tactical and long-term
strategic decision making.

1.1 Cost Accounting Terms

This section sets a foundation for the rest of the book by

describing the most important terms used in cost accounting.
An understanding of these terms will help in later sections to
understand how costs work, how they are reported, and how
decisions are taken using them.
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Introduction 3

Cost Object

Cost object is the product or service with respect to which cost

needs to be computed. For example, if a car manufacturer wants
to assess costs, the cars that they manufacture would be their cost
object. Similarly, the cost object for a bank would be its customer
accounts. Costs are classified on the basis of the cost object.

Direct and Indirect Costs

Costs are classified under two categories as given below:

Direct Costs

These are costs that can be directly traced or caused by a

product, service, project, organizational unit, or activity. For
example, the cost of a steering wheel is a direct cost in the
manufacturing of a car. Similarly, the cost of effort undertaken
by a worker in making the doors of the car also amounts to direct
cost. Below are some examples of direct costs:

a) Cost of cement used in the construction of a building

b) Cost of tires used in building a car

c) Cost of a project management consultant in the construction

of a bridge

Indirect Costs

These are costs that cannot be directly traced to a single

product, service, project, organizational unit, or activity. These
costs are allocated rather than being traced to individual
products or services as there is no cost-effective way of tracing
them directly. This allocation can be done in several ways, as
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4 Cost Accounting and Management Essentials You Always Wanted To Know

described in detail later. For example, the rent of a plant used to

manufacture cars of multiple varieties cannot be directly traced
to every car model. Hence, the rent is an indirect cost. If the plant
were to manufacture only one car model, then the rent would
become a direct cost. Similarly, the cost of supervisors for various
products of the company is also an indirect cost and needs to be
allocated in some proportion instead of being directly traced to the
products. Below are some examples of indirect costs:

a) Salary of staff in corporate headquarters

b) Cost of adhesive used in creating various products of the

company. This is especially because it may not be cost-
effective to try and relate this cost directly to each product.
It would be much better to allocate this cost on a certain
basis (an estimation)

c) Cost of power in a plant making many different products

Variable and Fixed Costs

When a company changes the number of products and/or

services it provides, its total costs would also change. However,
some costs change in relation to quantity or volume whereas
others do not. On this basis, these are the following categories of
costs: Variable Costs and Fixed Costs.

Variable Costs

Costs that change proportionately with volume are called

variable costs. So, if the company sells 10% more products, its
variable costs would also go up by 10%. For example, the cost of
car tires is variable and so is the cost of the steering wheel. We saw
earlier that both these costs are also Direct costs. Hence, a certain
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Introduction 5

cost can be Direct and at the same time, Variable. Below are some
other examples of variable costs.

a) Cost of paint required for a house

b) Cost of labor for manufacturing a truck

c) Cost of wood in constructing a house

The diagram and table below show how variable costs behave.

Figure 1.2

Variable Cost
35
30

25
20
Cost

15
10
5
0
0 5 10 15
Volume

Table 1.1

Units produced Variable cost Total variable

per unit cost
10 $500 $5,000
50 $500 $25,000
200 $500 $100,000

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6 Cost Accounting and Management Essentials You Always Wanted To Know

Non-variable/Fixed Costs

These are exactly the opposite of variable costs. They do not

vary with the quantity or volume of the product manufactured or
the service provided. This means that this cost is independent of
the volume. For example, the rent of office premises is a fixed cost
as it does not change with the change in business volume.

Below are some examples of fixed costs:

a) Cost of assembly line for a car model

b) Cost of supervisors

c) Cost of rent paid by a bank branch office

However, it may be noted that fixed costs are generally fixed

within a certain relevant range. For example, if the business grows
so much that a new office will have to be bought to accommodate
the new machinery and personnel, then the rent cost changes.
Hence, it is said to be fixed only over a certain volume of business
called the relevant range. The diagram and table below show how
fixed costs behave over the relevant range.

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Introduction 7

Figure 1.3

Fixed Cost (over relevant range)

20
Cost (scale x1,000)

15

10

0
0 5 10 20
Volume (units produced)

Table 1.2

Total Fixed cost Units produced Fixed cost per unit

$10,000 5 $2,000
$10,000 10 $1,000
$10,000 20 $500

Fixed costs are generally chunky costs or a step-function, as

they are incurred in chunks when one goes outside the relevant
range. So, if a new office is to be bought for additional space, the
fixed cost would increase by a large chunk equal to the rent of the
new office. It will then stay fixed until the business grows beyond
another higher relevant range. The following diagram and table
show how fixed costs behave across different relevant ranges.

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8 Cost Accounting and Management Essentials You Always Wanted To Know

Figure 1.4

Fixed Cost (across ranges)

40
35
Cost (scale x 1,000)

30
25
20
15
10
5
0
0 5 10 20
Volume (units Produced)

Table 1.3

Total Fixed cost Units produced Fixed cost per unit

$10,000 3 $3,333
$10,000 4 $2,500
$20,000 6 $3,333
$20,000 7 $2,857
$30,000 11 $2,727
$30,000 15 $2,000

Semi-variable Costs

Many costs are a combination of both the above costs. The

total amount in such costs will then change with volume, but
not proportionately. It is always best to try and separate this into
two components – fixed cost and variable cost, and deal with
them separately. For example, telephone bills usually contain a
fixed charge for having a connection and a variable charge based

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Introduction 9

on actual usage. In this case, it is easy to separate the two costs.

Similarly, the cost of driving a car includes many other cost
components, like the cost of gasoline, oil, tires, and maintenance,
all of which are variable. But there are also costs of insurance and
registration that are fixed. Hence, the total cost in both the above
cases is semi-variable and can be easily separated into its fixed and
variable components.

The two distinctions of costs – Direct and Indirect and Variable

and Fixed are on separate dimensions. Hence, every cost would be
a combination of these. The following combinations are possible:

a) Direct and Variable – Cost of car tires

b) Direct and Fixed – Rent of factory producing only one kind

of car

c) Indirect and Variable – Cost of power in a factory

producing several types of cars

d) Indirect and Fixed – Rent of factory producing several types

of cars

Unit Costs

Several times costs are quoted on a per-unit basis, like $5

per piece. This means that one piece costs $5. In this case, $5 is
a unit cost. However, there are important considerations while
computing unit costs.

Firstly, unit costs will remain constant for variable costs. So if

the unit variable cost is $5 per piece, it will remain the same even
if the volume doubles. But in cases where raw materials can be
procured cheaper in bulk and where economies of scale exist,
the unit variable cost could reduce. A similar effect can be seen if
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10 Cost Accounting and Management Essentials You Always Wanted To Know

the volume decreases significantly and volume discounts can no

longer be availed of.

Secondly, with the increase in volume, the fixed cost per

unit reduces and vice versa; volume and fixed cost per unit are
inversely proportional. The total fixed cost remains the same
irrespective of volume.

Calculating unit costs by taking all costs into consideration

will be misleading. Fixed costs should first be removed from the
total costs before unit cost calculations are computed. Below is an
example.

Number of units: 1,000

Total Variable cost: $10,000

Total Fixed cost: $50,000

Hence, Unit Variable cost = $10,000/1,000 = $10

Unit Fixed cost = $50,000/1,000 = $50

Total Unit cost = $10 + $50 = $60

Now if the company produces 2,000 units instead of 1,000, then

the unit costs will be as below:

Unit Variable cost = $10 (this will not change with number of
units)

Unit Fixed cost = $50,000/2,000 = $25

Total Unit cost = $10 + $25 = $35

Total Variable cost = $10 x 2,000 = $20,000

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Introduction 11

In summary, unit costs should always be computed by first

separating fixed costs from variable costs and keeping in mind the
effect of volume discounts and economies of scale.

Inventoriable Costs

All costs related to manufacturing that can be inventorized into

the company’s balance sheet are called inventoriable costs. They
fall under the following three categories:

a. Direct material costs – Cost of materials required to make

the product and whose cost can be traced back to the
product

b. Direct manufacturing labor costs – Cost of labor required

to make the product and whose cost can be traced back to
the product

c. Indirect manufacturing costs – Overhead costs that cannot

be directly traced to the product but are related to the
product

All inventoriable costs appear in the company’s balance sheet

under the item “Inventory” until the products are sold, after
which they appear in the company’s income statement under the
item “Cost of Goods Sold”.

Companies can have three types of inventory:

a. Direct materials inventory – Inventory of raw materials

b. Work-in-process inventory – Inventory of partially

manufactured products

c. Finished goods inventory – Inventory of ready products

that are not yet sold
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12 Cost Accounting and Management Essentials You Always Wanted To Know

Consider an example of a pencil manufacturer. They have the

following inventory levels:

Direct material (wood and lead) inventory: $500

Work-in-process inventory (including direct and indirect

manufacturing costs): $2,000

Finished goods inventory (including direct and indirect

manufacturing costs): $5,000

The company would show $7,500 ($500 + $2,000 + $5,000)

as inventory in its balance sheet this year. If the company has
managed to sell its entire finished goods inventory by next year
and there is no other change, then next year’s balance sheet will
show $2,500 ($500 + $2,000) as inventory and $5,000 will appear in
the cost of goods sold in next year’s income statement.

Period Costs

All costs that are not inventoriable are period costs. For
example, selling costs, marketing costs, R and D costs, and
distribution costs. These costs appear under expenses in the
income statement. They are not part of the cost of goods sold.
They never appear on the balance sheet.

Prime Costs

These are all direct manufacturing costs. They are computed as

follows:

Prime costs = Direct material costs + Direct manufacturing labor

costs

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Introduction 13

Conversion Costs

These are the costs incurred in converting the raw materials

into finished products. They are computed as given below:

Conversion costs = Direct manufacturing labor costs +

Manufacturing overhead costs

1.2 Using a Costing System

A costing system is used primarily for two purposes –

computing total cost incurred by a company, department, or
individual products/services and for making decisions using this
data.

Cost Computation
As discussed earlier, every company has Direct and Indirect
costs. Using these costs, companies compute the Cost of Goods
Sold (COGS), which is used for Financial Reporting via Income
Statement (refer to chapter “Income Statement” in the book
“Financial Accounting Essentials You Always Wanted to Know” of
Self-Learning Management Series).

The section below shows how the costing data is used to

compute the Cost of Goods Manufactured, which is then used to
compute the Cost of Goods Sold. The later chapters explain how
Indirect costs are allocated using Activity Based Costing (ABC)
and how Support Department costs are allocated.

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14 Cost Accounting and Management Essentials You Always Wanted To Know

Cost of Goods Manufactured

As the name suggests, Cost of Goods Manufactured is the cost

incurred in manufacturing goods. It includes only inventoriable
costs.

The diagram below shows how it is computed:

Figure 1.5

Begninning
Inventory
Inventoriable
. Costs
Direct Material
Direct Direct Material Used
Material Inventory
Purchased

Beginning
Ending
Inventory
Inventory

Direct
Manufacturing Work In
Labour Process Cost Of Goods
Inventory Manufactured
Indirect
Manufacturing
Overhead
Ending
Inventory

Consider the following example of how Cost of Goods

Manufactured is computed using the above diagram. The
following values are available for the year for a company:

a) Beginning inventory of Direct Materials = $500

b) Purchase of Direct Materials in the year = $200

c) Ending inventory of Direct Materials = $400

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