NM Cost & Management Accounting – I

Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

Difference between Cost Accounting and Management Accounting

Basis Cost Accounting Management Accounting

(i) Nature It records the quantitative It records both qualitative and
aspect only. quantitative aspect.
(ii) Objective It records the cost of It provides information to
producing a product and management for planning and
providing a service. co-ordination.
(iii) Area It only deals with cost It is wider in scope as it includes
Ascertainment. financial accounting, budgeting,
taxation, planning etc.
(iv) Recording of It uses both past and It is focused with the
data present figures. projection of figures for future.

(v) Development Its development is related Its development is related to

to industrial revolution. the need of modern business
world.
(vi) Rules and It follows certain principles It does not follow any specific
Regulation and procedures for rules and regulations.
recording costs of
different products.

Page 1 of 14
NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

Difference between Financial Accounting and Cost Accounting

Basis Financial Accounting Cost Accounting

(i) Objective It provides information about Ascertainment of cost for the

the financial performance of an purpose of cost control and
entity. decision making
(ii) Nature It classifies records, present It classifies, costs records,
and interprets transactions in present, and interprets it in a
monetary terms. significant manner.

(iii) Recordingof It records Historical data. It makes use of both

data historical and pre-determined
costs.

(iv) Users of The users of financial The cost accounting

information accounting statements are information is generally used
shareholders, creditors, by internal management. But
financial analysts and sometimes regulatory
government and its agencies, authorities also.
etc.

(v) Analysis of cost It shows profit or loss of the It provides the cost detailsfor
andprofit organization either segment each cost object i.e. product,
wise or as a whole. process, job, operation,
contracts, etc.

(vi) Time period Financial Statements are Reports and statements are
prepared usually for a year. prepared as and when
required.

(vii) Presentationof A set format is used for In general, no set formats for
information presenting financial presenting cost information
information. is followed.

Page 2 of 14
 NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

Classification of Cost
It means the grouping of costs according to their common
characteristics. Theimportant ways of classification of costs are:
(i) By Nature or Element
(ii) By Functions
(iii) By Variability or Behaviour
(iv) By Controllability
(v) By Normality
(vi) By Costs for Managerial Decision Making
(i) By Nature or Element
This type of classification is useful to determine the total cost.
A diagram as given below shows the elements of cost described as under:
ELEMENT OF COST

Material Cost Employee (Labour) Cost Other Expenses

Direct Material Indirect Direct Indirect Direct Indirect

Material Cost Employee Employee Expenses Expenses
Cost
(Labour) Cost (Labour) Cost

Production Administration Selling and

Overheads Overheads

1. Direct Materials: Materials which are present in the finished product (cost object) or can be
economically identified in the product are termed as direct materials. For example, cloth in dress
making; materials purchased for a specific job etc. However, in some cases a material may be
direct but it is treated as indirect because it is used in small quantities, it is not economically
feasible to identify that quantity. Those materials which are used for purposes ancillary to the
business are also treated as Indirect Materials.
2. Direct Labour: Labour which can be economically identified or attributedwholly to a cost object is
termed as direct labour. For example, employee engagedon the actual production of the product
or in carrying out the necessary operations for converting the raw materials into finished product.
3. Direct Expenses: All expenses other than direct material or direct labour which are specially incurred
for a particular cost object and can be identified in an economically feasible way are termed as
Direct Expenses. For example, hire charges for some special machinery, cost of defective work etc.

Page 3 of 14
 NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

4. Indirect Materials: Materials which do not normally form part of the finished product (cost object)
are known as indirect materials. These are —
• Stores used for maintaining machines and buildings (lubricants, cotton waste, bricks etc.)
• Stores used by service departments like power house, boiler house, canteenetc.
5. Indirect Labour: Labour cost which cannot be allocated but can be apportioned to or absorbed by
cost units or cost centres is known as indirectlabour. Examples of indirect labour includes salary
paid to foreman and supervisors; maintenance workers; etc.
6. Indirect Expenses: Expenses other than direct expenses are known as indirect expenses. These
cannot be directly, conveniently and wholly allocated to cost centres. Factory rent and rates,
insurance of plant and machinery, power, light, heating, repairing, telephone etc., are some
examples of indirect expenses.
7. Overheads: The aggregate of indirect material costs, indirect labour costsand indirect expenses
is termed as Overheads. The main groups into which overheads may be subdivided are as follows:
• Production or Works Overheads: Indirect expenses which are incurred inthe factory
and for the running of the factory. E.g.: rent, power etc.
• Administration Overheads: Indirect expenses related to management andadministration of
business. E.g.: office rent, lighting, telephone etc.
• Selling Overheads: Indirect expenses incurred for marketing of a commodity.E.g.:
Advertisement expenses, commission to sales persons etc.
• Distribution Overheads: Indirect expenses incurred for dispatch of thegoods E.g.:
warehouse charges, packing(secondary) and loading charges.

(ii) By Function
Under this classification, costs are divided according to the function for which theyhave been
incurred. It includes the following:
(i) Direct Material Cost
(ii) Direct Employee (labour) Cost
(iii) Direct Expenses
(iv) Production/ Manufacturing Overheads
(v) Administration Overheads
(vi) Selling Overheads
(vii) Distribution Overheads
(viii) Research and Development costs etc.

Page 4 of 14
 NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

(iii) By Variability or Behaviour

Based on this classification, costs are classified into three groups viz., fixed, variable and semi-
variable.
(a) Fixed costs– These are the costs which are incurred for a period, and which, within certain output
and turnover limits, tend to be unaffected by fluctuations inthe levels of activity (output or
turnover). They do not tend to increase or decrease with the changes in output. For example, rent,
insurance of factory building etc.,remain the same for different levels of production.
(b) Variable Costs– These costs tend to vary with the volume of activity. Any increase in the activity
results in an increase in the variable cost and vice-versa. For example, cost of direct material, cost of
direct labour, etc.
(c) Semi-variable costs– These costs contain both fixed and variable components and are thus partly
affected by fluctuations in the level of activity. Examples of semi variable costs are telephone bills,
gas and electricity etc.

(iv) By Variability or Behaviour

Costs here may be classified into controllable and uncontrollable costs.
(a) Controllable Costs: - Cost that can be controlled, typically by a cost, profitor investment centre
manager is called controllable cost. Controllable costs incurred in a particular responsibility centre
can be influenced by the action of the manager heading that responsibility centre. For example, direct
costs comprising direct labour, direct material, direct expenses and some of the overheads are
generally controllable by the shop floor supervisor or the factory manager.
(b) Uncontrollable Costs - Costs which cannot be influenced by the action of a specified member of
an undertaking are known as uncontrollable costs. For example, expenditure incurred by, say, the
tool room is controllable by the foreman in-charge of that section but the share of the tool-room
expenditure which is apportioned to a machine shop is not controlled by the machine shop
foreman.
Distinction between Controllable Cost and Uncontrollable Cost: The distinction between
controllable and uncontrollable costs is not very prominent and is sometimes left to individual
judgement. In fact, no cost is uncontrollable; it is onlyin relation to a particular individual that
we may specify a particular cost to beeither controllable or uncontrollable.
(v) By Normality
According to this basis, cost may be categorised as follows:
(a) Normal Cost - It is the cost which is normally incurred at a given level ofoutput under the
conditions in which that level of output is normally attained.
(b) Abnormal Cost - It is the cost which is not normally incurred at a given level of output in the
conditions in which that level of output is normally attained. It is charged to Costing Profit and
loss Account.

Page 5 of 14
NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

METHODS OF COSTING
Different industries follow different methods of costing because of the differencesin the nature
of their work. The various methods of costing are as follows:

Methods Description
Single or Under this method, the cost of a product is ascertained, the
Output Costing product being the only one produced like bricks, coals, etc.
Batch Costing This method is the extension of job costing. A batch may represent a
number of small orders passed through the factoryin batch. Each batch
here is treated as a unit of cost and thus separately costed. Here cost per
unit is determined by dividing the cost of the batch by the number of
units produced in the batch.

Job Costing Under this method of costing, cost of each job is ascertained separately.
It is suitable in all cases where work is undertaken on receiving a
customer’s order like a printing press, motor workshop, etc.

Contract Costing Under this method, the cost of each contract is ascertained separately. It
is suitable for firms engaged in the construction of bridges, roads,
buildings etc.

Process Costing Under this method, the cost of completing each stage of work is
ascertained, like cost of making pulp and cost of making paper from
pulp. In mechanical operations, the cost of each operation may be
ascertained separately; the name given is operation costing.

Operating It is used in the case of concerns rendering services like transport, supply
Costing of water, retail trade etc.

Multiple Costing It is a combination of two or more methods of costing outlined above.

Suppose a firm manufactures bicycles including its components; the
parts will be costed by the system of job or batch costing but the cost of
assembling the bicycle will be computed by the Single or output costing
method. The whole system of costing is known as multiple costing.

Page 6 of 14
 NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

(i) Re-order Stock Level (ROL): This level lies between minimum and the maximum levels in such a way
that before the material ordered is received into the stores, there is sufficient quantity in hand to
cover both normal and abnormalconsumption situations. In other words, it is the level at which
fresh order shouldbe placed for replenishment of stock.
It is calculated as:

ROL = Maximum Consumption × Maximum Re-order Period

Maximum Consumption = The maximum rate of material consumption

in
production activity
Maximum Re-order period = The maximum time to get order from
supplierto the stores
This can also be calculated alternatively as below:

ROL = Minimum Stock Level + (Average Rate of Consumption × Average Re-order

period)

Minimum Stock Level = Minimum Stock level that must be

maintainedall the time.
Average Rate of Consumption = Average rate of material consumption in
production activity. It is also known as normal consumption/ usage
Average Re-order period = Average time to get an order from supplier to
the stores. It is also known as normal period. (Re-order period is also known as Lead
time)

(ii) Re-Order Quantity: Re-order quantity is the quantity of materials for which purchase requisition
is made by the store department. While setting the quantityto be re-ordered, consideration is
given to the maintenance of minimum level of stock, re-order level, minimum delivery time and the
most important the cost. Hence, the quantity should be where, the total of carrying cost
and ordering cost is at minimum. For this purpose, an economic order quantity should be
calculated.
Economic Order Quantity (EOQ): The size of an order for which total of ordering and carrying
cost are minimum.

Ordering Cost: Ordering costs are the costs which are associated with the purchase or order
of materials such as cost to invite quotations, documentation works like preparation of purchase
orders, employee cost directly attributable to the procurement of material, transportation and
inspection cost etc.

Carrying Cost: Carrying costs are the costs for holding/ carrying of inventories in store such
as the cost of fund invested in inventories, cost of storage, insurancecost, obsolescence
etc.

Page 7 of 14
 NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

The Economic Order Quantity (EOQ) is calculated as below:

2 ×Annual Requirement (A) ×Cost per order (O)

EOQ =
Carrying Cost per unit per annum (C)

Annual Requirement (A)- It represents demand for raw material or Input for a year.

Cost per Order (O) - It represents cost of placing an order for purchase.

Carrying Cost (C) – It represents cost of carrying average inventory on annual basis.

Assumptions underlying E.O.Q.: The calculation of economic order of material tobe

purchased is subject to the following assumptions:

(i) Ordering cost per order and carrying cost per unit per annum are known andthey are
fixed.
(ii) Anticipated usage of material in units is known.
(iii) Cost per unit of the material is constant and is known as well.
(iv) The quantity of material ordered is received immediately i.e. the lead time iszero.

Activity Based Costing is an accounting methodology that assigns costs to activities rather than
products or services. This enables resources & overhead costs to be more accurately assigned to
products & services that consume them. ABC is a technique which involves identification of cost
with each cost driving activity and making it as the basis for apportionment of costs over
differentcost objects/ jobs/ products/ customers or services.

ABC can track the flow of activities in organization by creating a link between the activity (resource
consumption) and the cost object.
CIMA defines ‘Activity Based Costing’ as “An approach to the costing and monitoring of activities which
involves tracing resource consumption and costing final outputs. Resources are assigned to activities,
and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach
activity costs to outputs.”

Cost Driver–It is a factor that causes a change in the cost of an activity.

Examples of Cost Drivers:

Business functions Cost Driver

Research and Development • Number of research projects
• Personnel hours on a project
Design of products, services • Number of products in design
and procedures • Number of parts per product
• Number of engineering hours

Page 8 of 14
NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

Customer Service • Number of service calls

• Number of products serviced
• Hours spent on servicing products
Marketing • Number of advertisements
• Number of sales personnel
• Sales revenue
Distribution • Number of units distributed
• Number of customers

Cost Allocation under Traditional and Activity Based Costing System

In traditional absorption costing overheads are first related to cost centres (Production & Service
Centres) and then to cost objects, i.e., products. In ABC overheads are related to activities or grouped
into cost pools. Then they are relatedto the cost objects, e.g., products. The two processes are,
therefore, very similar, but the first stage is different, as ABC uses activities instead of functional
departments (cost centres). The problem with functional departments is that they tend to include a
series of different activities, which incur a number of different costs that behave in different ways.
Activities also tend to run across functions; for instance, procurement of materials often includes
raising a requisition note in a manufacturing department or stores. It is not raised in the purchasing
department where most procurement costs are incurred. Activity costs tend to behave in asimilar
way to each other i.e., they have the same cost driver. Therefore, ABC givesa more realistic picture
of the way in which costs behave.

Activity Based Costing Traditional Absorption Costing

1. Overheads are related toactivities 1. Overheads are related to cost
and grouped into activity cost centers/departments.
pools.
2. Costs are related to activities and 2 Costs are related to cost centers and
hence are more realistic. hence not realistic of cost
behaviour.
3 Activity–wise cost drivers are 3. Time (Hours) are assumed to be the
determined. only cost driver governing costs in
all departments.
4. Activity–wise recovery rates are 4. Either multiple overhead recovery
determined and there is no rates (for each department) or a
concept of a single overhead single overhead recovery rate may
recovery rate. be determined for absorbing
overheads.
5. Cost are assigned to cost objects, 5. Costs are assigned to Cost Units
e.g. customers,products, services, i.e. to products, or jobs or hours.
departments, etc.

Page 9 of 14
 NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

6. Essential activities can be simplified 6. Cost Centers/ departments cannotbe

and unnecessary activities can be eliminated. Hence, not suitable for
eliminated. Thus, the cost control.
corresponding costs are also
reduced/ minimized. Hence ABC
aids cost control.

Time based (Time Rate System)

Straight Time Rate System: Under this system, the workers are paid on time basis
i.e. hour, day, week, or month. The amount of wages due to a worker are arrived atby multiplying the
time worked (including normal idle period) by rate for the time.

Time based wages payment is suitable for the employees (i) whose services cannotbe directly or
tangibly measured, e.g., general helpers, supervisory and clerical staff etc. (ii) engaged in highly
skilled jobs, (iii) where the pace of output is independentof the operator, e.g., automatic chemical
plants.
Wages under time rate system is calculated as under:

Wages = Time Worked (Hours/ Days/ Months) × Rate for the time

Output Based (Piece Rate System)

Straight Piece Rate System: Under this system, each operation, job or unit of production is
termed a piece. A rate of payment, known as the piece rate or piece work rate is fixed for each
piece. The wages of the worker depend upon his output and rate of each unit of output; it is in fact
independent of the time taken by him. The wages paid to a worker are calculated as:

Wages = Number of units produced × Rate per unit

Premium Bonus Method

Under these methods, standard time is established for performing a job. The workeris guaranteed
his daily wages (except in Barth System), if his output is below andupto standard. In case the
task is completed in less than the standard time, thesaved time is shared between the employee
and the employer.
(i) Halsey Premium Plan: Under Halsey premium plan a standard time is fixedfor each job or process.
If there is no saving on this standard time allowance, the worker is paid only his day rate. He gets his
time rate even if he exceeds the standard time limit, since his day rate is guaranteed.
If, however, he does the job in less than the standard time, he gets a bonus equalto 50 percent
of the wages of time saved; the employer benefits by the other 50 percent. The scheme also is
sometimes referred to as the Halsey fifty percent plan. Earnings under Halsey Premium plan is
calculated as under:
Wages = Time taken × Time rate + 50% of time saved × Time rate

Page 10 of 14
 NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

Advantages and Disadvantages of Halsey Premium Plan

Advantages Disadvantages
1. Time rate is guaranteed while there is 1. Incentive is not so strong aswith
opportunity for increasing earnings by piece rate system. In fact the
increasing production. harder the worker works, the
2. The system is equitable in as much as lesser he gets per piece.
the employer gets a direct return for his 2. The sharing principle may not
efforts in improving production be liked by employees.
methods and providing better
equipment.

(ii) Rowan Premium Plan: According to this system a standard time allowance is fixed for the
performance of a job and bonus is paid if time is saved.
Under Rowan System the bonus is that proportion of the time wages as time
savedbears to the standard time.
Time Saved
Time taken × Rate per hour + × Time taken × Rate per hour

Advantages and Disadvantages of Rowan Premium Plan

Advantages Disadvantages
1. It is claimed to be a fool-proof system inas 1. The system is a bit
much as a worker can never double his complicated.
earnings even if there is bad rate setting.

2. It is admirably suitable for encouraging 2. The incentive is weak at a high

moderately efficient workers as it production level where the time
provides a better return for moderate saved is more than50% of the time
efficiency than under the Halsey Plan. allowed.
3. The sharing principle appeals to the 3. The sharing principle is not generally
employer as being equitable. welcomed by employees.

Page 11 of 14
 NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

Advantages of Piece Rate System Disadvantages of Piece Rate System

Workers pay much more attention to quantity

Increases the efficiency of all the employees
and not quality

They do not constantly require any kind of

Planning for the future becomes rather tough
micromanagement

It is very easy to calculate the dues of the Finding and fixing on a reasonable piece cost
worker is a rather tough task

Workers do not end up wasting any time It puts immense pressure on all the employee

They are encouraged to think of better

Sometimes even more super vision is required
working methods

The number of products produced is much Mishandling of Plant & Machinery may give
higher rise to wear and tear

Mishandling of Raw Material may give rise to

The workers set deadlines for themselves
wastage

Page 12 of 14
NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

Several methods are commonly employed either individually or jointly for computing the
appropriate overhead rate. The more common of these are:

Methods of Absorption of Overheads

Percentage Percentage Percentage

of prime of direct Labour hour Machine Rate per unit
of direct
rate hour rate of Output
materials cost labour cost

(1) Percentage of direct materials,

(2) Percentage of prime cost,
(3) Percentage of direct labour cost,
(4) Labour hour rate,
(5) Machine hour rate and
(6) Rate per unit of Output

Percentage of Direct material cost

Under this method, the cost of direct material consumed is the base for calculating theamount of
overhead absorbed. This overhead rate is computed by the following formula:

Total Production Overheads of a Department

Overhead rate = ×100

Percentage of Prime cost method

This method is based on the fact that both materials as well as labour contribute in raising
factory overheads. Hence, the total of the two i.e. Prime cost should be taken as base for
absorbing the factory overhead. The overhead rate in this method is computed by the
following formals:

Total Production Overheads of a Department

Overhead rate = ×100
Prime cost

Page 13 of 14
 NM Cost & Management Accounting – I
Bcom Mgmt & Finance Compiled by CA Sapan Sir (Ref: ICAI)

Percentage of direct labour cost

Formula to be used under this method is- Direct Labour Cost Percentage Rate

Total Production Overheads of a Department

Overhead rate = ×100
Direct Labour cost

Labour hour rate Method

This method is an improvement on the percentage of direct wage basis, as it fully recognises
the significance of the element of time in the incurring and absorption of manufacturing overhead
expenses. This method is admirably suited to operations whichdo not involve any large use of
machinery. To calculate labour hour rate, the amount of factory overheads is divided by the
total number of direct labour hours. Suppose factory overheads are estimated at `90,000 and
labour hours at 1,50,000. The overheadabsorption rate will be `0.60. If 795 direct labour hours
are spent on a job, `477 will beabsorbed as overhead. It can be calculated for each category of
workers.
Formula to be used under this method is-

Total Production Overheads of a Department

Direct Labour Hour Rate = ×100
Direct Labour Hour

Machine hour rate Method

Machine hour rate implies, cost of running a machine for an hour to produce goods. There are two
methods of computing machine hour rates:
(i) Direct Machine hour rate: According to the first method, only the expenses directly or
immediately connected with the operation of the machine are taken into account e.g., power,
depreciation, repairs and maintenance, insurance, etc. The rate is calculated by dividing the
estimated total of these expenses for a period by the estimated number of operational hours of
the machines during the period.
(ii) Comprehensive Machine hour rate: It will be obvious, however, that in addition to the expenses
stated above there may still be other manufacturing expenses such as supervision charges, shop
cleaning and lighting, consumable stores and shop supplies, shop general labour, rent and rates,
etc. incurred for the department as a whole and, hence, not charged to any particular machine or
groupof machines. In order to see that such expenses are not left out of production costs, one should
include a portion of such expenses to compute the machine hour rate. Alternatively, the overheads
not directly related to machines may be absorbed onthe basis of Productive Labour Hour Rate
Method or any other suitable method

Page 14 of 14